Life Insurance: Term vs. Whole Life
Want a quick test to see if you’re truly an “adult”? let’s talk about life insurance! -Quiet sobs-
I’ll be honest and say that insurance is one of the topics I’ve avoided learning much about, and especially life insurance. It is in no way a fun topic, but if we’re talking about financial wellbeing, then insurance has to part of the picture.
The really, really short description:
While there are many different variations of life insurance out there, there are two broad categories that you need to be aware of: Term Insurance and Permanent Insurance (most commonly as “Whole Life Insurance”). Term Insurance is insurance over a specific time period (10, 20, or 30 years), while Permanent Insurance stays with you your whole life (as long as you continue to pay the insurance payments).
Term Insurance Explained:
We’ll start with the easy one, term insurance. It’s easy because it’s quite simple and fits into our logical framework of what life insurance is all about: financial relief in the event of early death. Term Insurance’s purpose is to provide a financial umbrella over your family in case anything goes terribly wrong. This means it’s most useful for those who have financial dependents and especially during a time where your income is the primary source of financial wellbeing; meaning you don’t already have $1 million dollars set aside for your dependents to live off from.
I’ll break this down even more simply just in case the purpose hasn’t even been properly conveyed before. If you have children, a spouse, parents, etc. who depend on you to provide for them, you can say that they are financially dependent on you. I’ll try to limit the amount of references to death, so we can use a parallel equivalent and say, what would happen to them if you no longer earned any more money, perhaps due to injury or due to lay offs (not factoring in welfare)? How much money would those who depend on your income need to remain financially comfortable? If you haven’t saved up a bunch of money, what is going to happen to them? Ideally, you would have been financially prudent and started saving and investing funds over the years and that one day your dependents would have access to those funds and that would financially support them, but it takes time to build up that kind of capital, and in the meantime, life insurance fills in that gap.
When we talk about this end result of life insurance, what we’re referring to is called the “Death Benefit.” When you select a life insurance plan, one the things you need to determine is how much money you would want your dependents to receive in the event of death.
Let’s return back to Term Insurance. All that Term Life Insurance is, is a death benefit insurance over a specified period of time. For the most part, all you need to do is decide how many years you want to insure yourself for, and how much you want the payout to be. Determining those answers though, does require a little more thought however.
Since Term Insurance has an expiration date, you need to determine how long you need this kind of protection. If we’re looking at this from the essentials, how much time do you need until you either no longer need to provide for dependents or to build up enough personal wealth that would take care of your dependents? If the dependent is a child, then in most cases, they will not remain a dependent of yours forever since they will grow up and provide for themselves, which in that case, all you need is to have insurance until they reach a point of financial self-sufficiency. If a dependent is going to be a more permanent situation, then you’ll have to determine the nest egg size of wealth you must have that your dependent could live off of indefinitely.
What this means is that there could be a point (maybe in the near future) where you just simply don’t need life insurance since those who needed it either will at some point not need it, or you could have that resource yourself.
There’s another factor when it comes to determining length, and that is the cost factor. Since this is insurance, that means there’s going to be a lot of statistical probabilities that the insurer is relying on when determining how much to charge you. Since the older you get, you’re statistically more likely to die, every extra year you cover yourself makes it more likely that the insurance is going to be liable for paying the death benefit and thus will charge you more.
This creates what would seem to be a counter-intuitive price at first glance, in that a 30 year term insurance is going to be about double the price per month as a 10 year term insurance. We’re used to thinking bundling and longer commitments provide us a discount, but in the world of insurance, our roles are switched since it’s the insurer who’s on the line for a big cost and we’re the ones who benefit for having a longer commitment.
Here’s another dilemma to be aware of: Let’s say you bought a 20 year term insurance, and after 20 years, you decide to get another 20 year term insurance policy, your new policy’s monthly premiums could easily be 300% the price you paid for the last one. Since you’re having to get insurance for a whole new set of years when you are now already 20 years older, the cost of each year is exponentially higher from the first time you bought 20 year life insurance. This is why you need to think carefully about how many years you want your term insurance to cover, so you don’t have to take out a second policy that is signficiantly more expensive.
To demonstrate with real quote estimates, I went to State Farm’s quote estimator & for me at age 28, to get a $1,000,000 twenty year term life insurance, I would pay $50/mo for those 20 years. If I was 48, and got the same policy, the monthly premium is $146.
Just like every extra year increases the probability that the insurer is going to have to pay out an insurance policy, the amount they’re going to pay is an important metric as well. This means the bigger insurance policy you take out, the more expensive your monthly payments are going to be as well.
All this means is that it is really expensive to get that second policy after the first one expires, and trying to cover a large amount of years is also going to be very costly. Also if you want to have a lot of insurance, it’s also going to dramatically increase your monthly cost as well.
Pros and Cons of Term:
Now that we know the basic function of how Term Life Insurance works, we can observe the comparative value it has.
When you’re getting term insurance, you’re getting the most basic aspect that insurance provides and that’s, well, insurance. This means that Term Insurance is going to be the cheapest form of life insurance on the market.
Easy to Understand:
The other benefit to being a plain vanilla insurance is that most of it is self-explanatory. Each policy is still going to be different, and each insurer will have different clauses in there that can have an impact. Some insurers may have different add-on services as well, but for the most part, you just need to determine how much insurance you want and for how long, and you can get a quote pretty quick.
In one viewpoint, Term Insurance is a win-win situation: either in the midst of terrible tragedy comes the financial relief of the insurance payout, or you live beyond the policy and lose out on the money but you get your life. It’s kind of like betting on the team that’s playing your favorite team, in that either you get the team win or you get the money. The flip side to this is its money going down the drain. This is where the Permanent Insurance will try to fill in the gap, but you’re most likely paying money to cover an event that’s most likely not going to happen and in essence throwing it away when you could have made that money work for you.
If you’ve ever took a glance at life insurance, you most likely came across a form of Permanent Life Insurance. I’m just going to focus on Whole Life Insurance since that is the on the opposite side of the spectrum from Term Life and is also the most popular form of permanent insurance. I’m going to do my best to balance simplifying this but not overly so, because Whole Life insurance is much more complicated and there’s a lot more variability in types of Whole Life that make it hard to make good generalizations.
How Whole Life Insurance works, is not only does it have the typical death benefit payout, but it also has a form of savings built into as well in addition to there not being an expiration date. Since there isn’t an expiration date (some have a maturity date at age 100 though), Whole Life isn’t as much about covering family expenses in the event of early death, but rather as a form of estate planning that you’re setting up for passing down wealth to the next generation. You can also look at it as a form of pre-ordering an investment; that is, if you had a $1 million dollar policy, you’re reserving $1 million dollars to be cashed out after you die even if you don’t have it currently.
Since the insurer knows that they’re definitely going to pay the $1 million dollars and not just a probability, they are going to charge you a lot more. With Term insurance the question was “if” they were going to payout $1 million, but with Whole Life, the question is “when.” So keep that in mind, since there’s going to be a lot more weird things going on and it’s because the insurance company is having to answer a completely different question with Whole Life.
When you get a Whole Life Insurance policy, your monthly payment goes to primarily three things: Insurance Premium (i.e. payment), maintenance fees, & funding your cash balance.
This will probably be the most confusing part of Whole Life, because the Cash Balance plays a bunch of different roles. The short answer is it’s like a savings account; after you pay the monthly premium and fees, the rest of your payment funds the cash balance, which will continue to grow over time as you keep making payments. You can even borrow against the cash balance at a rate lower than most bank loans. But that is kind of misleading though because the ultimate purpose of this is to offset the risk you incur as you get older. In the insurer’s eyes, the cash balance is actually your payment towards the $1 Million Dollar bill they have in the future. This is because even though it’s called a “Cash Balance” and you can even have some form of access to it while you’re alive, that balance is not going to be added to the $1 Million insurance payout when you die, but rather the insurer is going to keep it as a way to offset the cost of paying you $1 Million Dollars.
Let me explain in simple terms. If you paid $850 per month (yes, we’ll get to that huge number later), the first $50 is going to cover the premium and fees, just like a Term Insurance would. The other $800 would go towards the cash balance & fees. When we fast forward to 20 years from now, you’re still making $850 per month, but now $150 of that is going towards the premium, and $700 goes towards the cash balance. The reason it changes is because every year, the likelihood you’re about to die increases and that still means they’ll have to pay out $1 million. But what also is happening with that cash balance is after that 20 years of deposits, it may worth $150,000 now. Which to the insurer, they now look at your $1 Million insurance as actually $850,000 insurance since you’ve already provided $150,000 to offset the bill.
It is kind of screwed up, but again, Whole Life is a guaranteed $1 Million Dollar payout, and since it’s a guarantee, the insurer looks at it not as insurance but rather more like some kind of delayed loan that you’re paying off. So the older you get, the more you’re actually paying off the $1 Million policy with your cash balance, and if you live a long prosperous life, you will have a cash balance of $1 Million that you contributed towards, and the insurer just made sure in case you died early, there was $1 Million for someone.
Whole Life analogies:
I know it’s confusing, so here’s a couple of analogies to help reframe how cash balances work. The most common example would be to compare it to a mortgage, but as if it was were inverted. You can look at the mortgage itself as the life insurance policy, and the house is the $1 Million Dollars. In a normal mortgage, there are two components: Principle and Interest. At first you pay mostly interest, but as you get momentum, you start paying off more of the principle until eventually you pay off the whole mortgage. But Whole Life would be like if the process was inverted so that you mostly paid Principal in the early years and towards the end paid mostly in interest. So then the Cash Basis would be the inverted Principal and the Premium would be the inverted Interest payment.
After years of paying this mortgage, you will have eventually paid off the $1 million mortgage and have a fully paid for house worth $1 million, but you had to pay the $1 million plus interest to have it. In this analogy, if you died before you had paid off the mortgage, your family would still get this $1 Million Dollar house, and the insurer keeps whatever principal you paid.
Another way to look at Whole Life is like an inverted bond: You issue out a $1 million bond, which every month you pay a coupon rate out towards that covers both the interest and the principal of the bond. After many years, you will have made enough payments that you’ll have a $1 Million Dollar Bond, but you paid $1 Million Dollars plus interest to have it. But if you died before paying $1 Million Dollars, your family would still get the full bond.
Hopefully you’re still there after all that. It is very confusing so it’s ok if you still don’t fully understand, but I hope you at least have a sense of what is going on now. Just remember that the insurance is more like a loan, and the cash balance is what you’ve paid off so far, rather than it being additional savings.
Pros and Cons:
A Whole Life Policy assures there is going to be some sort of payout to your dependents or inheritance after you die. In financial planning terms, it guarantees that you’ll “leave a legacy” to those you desire to pass on your assets to.
It can be treated as part of diversifying your portfolio as the conservative anchor. You build up a cash value and it even gets a low interest rate (mostly called Dividends) of around 2% per year.
The Death Benefit is issued income-tax-free to your beneficiaries, and thus since the Death Benefit is essentially guaranteed with a Whole Life policy (as long as you keep it your whole life), it is an effective way to pass over your inheritance with minimal tax implications.
You can take a loan out on the current cash balance you have at a very low rate, which provides you access to liquid capital at a low rate and isn’t treated as income since it’s from taxable income that you deposited this cash balance in the first place. The downside to this is you’re literally paying interest payments to have access to your own money. The counter to that is if this was in an IRA instead and you needed access to a large amount of capital, you would be hit with high early withdrawal fees if you pulled funds out of the IRA for the same situation.
Whole Life is very expensive, expect to be paying over $800 per month for the rest of your life towards it. Roughly 40% of policies are cancelled within 10 years.
Comparing the two types:
One of the most common examples of comparing these two services is to say Term is like renting a house, while Whole Life is like owning a house, but I find this very misleading. The illustration goes like this: Do you want to make payments that just do the job and are left with nothing at the end or do you want to be contributing towards owning the house and have your payments go towards something valuable? In one sense it is accurate- Term insurance is a rental service while Whole Life is ownership. The problem with this analogy is insurance isn’t perfectly comparable to housing. That is because the monthly payment is on average lower for home owners than it is home renters (but home owners have to put up a huge down payment in order to be in this situation). Meanwhile with insurance, the monthly payment is significantly lower for Term insurance compared to Whole Insurance. In fact, Term Insurance is on average around 1/20ththe price that Whole Life Insurance cost per month. In my personal quote, of 20 years, $1 Million Term Life Insurance was $50/month while $1 Million Whole Life Insurance was going to be $879/month, which is almost 18 times the monthly cost of Term.
This is important because what this means is you could take the $829/month you save by having Term over Whole, and invest that towards retirement and could potentially have that same $1 Million to give to your inheritance but without the fees and still getting life insurance covered for the time you didn’t get the $1 Million in wealth.
But Whole Life does allow easier access to capital over other investment accounts if you need large amount of cash that exceeds your bank balance on the cheap.
The DIY Whole Life Policy:
Using my quote of $50/month for 20 years Term insurance, we would have an additional $829/month free to invest. Let’s say we max out our Roth and Traditional IRAs and got the average growth of the S&P 500 of 9.8% per year. By the time our 20 year term insurance is up, we would have $619,269. So if you died the very next day after your Term Insurance ended, you would missed out on almost $400,000.
If we wanted to do it ourselves, we would need to draw out the Term insurance more in order to match the Whole Life Insurance ourselves if we died outside the term policy coverage. For 30 year Term Insurance quoted by State Farm, I would pay $82/Month for the $1 Million policy. Which using the same growth chart, after 30 years with $797 invested monthly ($879 – $82 = $797), we would have an investment worth $1,741,427! That means that if we died the day after the 30 year policy expired, we would miss out on the $1 Million Death Benefit, but we would have $1.7 Million in investments instead.
There are some unique benefits that Whole Life insurance brings, especially when comes to estate planning, but overall it seems to be a top-heavy asset that will be too costly for the average individual. Term Life Insurance is definitely the easiest, cheapest, and safest insurance product that will appeal the majority of people. I know there’s still a lot about Whole Life Insurance that I don’t understand and can reveal other advantages to you, but one of the most important things about personal finance is understanding what you’re doing, so just be careful and have a firm footing before you jump into one of these products.