There are really only two types of life insurance — permanent and term — although the two types come in many shapes, sizes, and colors. The biggest difference between them is how long the coverage lasts:
Permanent life insurance covers you for your entire life. Your death is certain. And when you die, it pays the death benefit (the amount of money payable at the time of death).
Term life insurance covers only a part of your lifetime. When that part, or term, ends, so does the coverage. It only pays a death benefit if you die within the designated term.
In a nutshell, what is the difference between whole life and term insurance, and which one is better for you? Both types of policies remain popular and easy to understand. Let’s look at the key features of these insurance mainstays.
Term Life Insurance
Term life insurance contracts are differentiated based on the length of the coverage term, whether they can be renewed, the length of the price guarantee, and whether they can be converted to permanent insurance.
This insurance is pure life insurance. You pay an annual premium for which you receive a particular amount of life insurance coverage. If you, the insured person, pass away, your beneficiaries collect; otherwise, the premium is gone, but you’re grateful to be alive!
Term life insurance is ideally suited for covering life insurance needs that are not permanent. For example, you may buy term life insurance when you want to cover a 20-year mortgage, college costs for children, or family income needs while the kids are growing up.
When you retire, you don’t need life insurance to protect your employment income, because there isn’t any to protect! You may need life insurance when you’re raising a family and/or you have a substantial mortgage to pay off, but by the time you retire, the kids should be out on their own (you hope!), and the mortgage should be paid down.
In the meantime, term insurance saves you a tremendous amount of money. For most people, it takes 20 to 30 years for the premium they’re paying on a term insurance policy to finally catch up to (equal) the premium they’ve been paying all along on a comparable amount of cash value life insurance.
Term life insurance costs, unlike permanent life insurance costs, increase regularly as you age. Sometimes the increase is annual, and sometimes it’s every five or ten years or more. Term insurance costs can be averaged over 10, 20, or 30 years, so the price is level for the
entire term. But term insurance doesn’t have a cash value element — if you drop a term insurance policy in its early years, you get no refund of any overpayment.
Because term insurance has no cash value element, premiums in the first several years are considerably lower than permanent insurance premiums for the same death benefit.
Permanent Life Insurance
Permanent life insurance is ideally suited to permanent needs. For example, you may buy permanent life insurance when you’re looking to supplement retirement dollars for your surviving spouse, covering estate taxes due upon your death, or paying final expenses — burial, legal costs, and so on.
Every life insurance policy has two core parts to its price:
- Mortality cost: This is determined by your odds of dying at that moment. The mortality charge increases each year as you age and your risk of dying increases.
- Policy expense cost: This is your share of insurance company expenses (rent, staff, and agent commissions). The expense charge stays relatively constant.
Most permanent life insurance policies have level premiums for life. How is that possible if the mortality charge increases each year? The insurance company averages the increasing mortality changes over your remaining expected life. In short, you overpay in the early years
so that you can underpay in the later years. That overpayment in the early years is set aside in a reserve for you, called cash value. If you cancel a permanent policy, by law you’re entitled to get back much of those overpayments — that cash value. The cash value is minimal in the first couple of years because of heavy first-year costs — underwriting, medical exams, and agent commissions.
In most whole life policies, you pay the same monthly premium for the whole policy’s duration. There are two ways to split those premiums. A portion of your payment goes toward the insurance component, while the other part builds your cash value.
While most providers guarantee interest rates (often 1% to 2% annually), some offer participating policies that pay unguaranteed dividends that can increase your total return.
In the beginning, whole life premiums are higher than the actual cost of the insurance. When you get older, that reverses, and you’ll pay less than you would with a typical term policy.
If you borrow or withdraw from your cash value account, later on, you can pay tuition for your child or make home repairs with your tax-deferred money. This makes it a much more flexible financial tool than a term policy. You won’t have to pay income tax on the loans you receive from your policy, but you will have to pay tax on investment gains if you withdraw money from it.
Death benefits and cash values are not entirely separate features. Taking a loan from your policy will reduce your death benefit if you do not pay it back. As an example, if you take out a $50,000 loan and the loan is still outstanding, your beneficiaries will receive $50,000 less.
Permanent life insurance is considerably more expensive than term life insurance for the first several years, for the same death benefit, because permanent insurance has a cash value element.
The complexity of whole life insurance is another potential drawback. A term policy, on the other hand, allows you to simply stop making payments if you no longer require or can afford the insurance.
If you decide to walk away from your whole life policy, your carrier may assess a surrender charge of up to 10% of the cash value. Over time, this charge usually diminishes until it eventually disappears.
Which is Better? Term or Whole Life Insurance?
The answer is that it depends on your needs and wants. If you have a nonpermanent need, term life insurance might be better. Examples of nonpermanent needs include covering living expenses while the children are growing up, paying off a mortgage, or paying for the children’s college education.
If you have a permanent need, then permanent life insurance should be a better choice. A permanent need is a need that, no matter how old you are today, will require cash for your survivors when you die — paying estate taxes, supporting an adult child with Down’s syndrome in a group home, continuing to support a favorite charity after your death or providing supplemental lifetime income to a surviving spouse.
The cash value accumulation of whole life insurance also offers several living benefits, reducing its overall cost over time.
You may or may not need life insurance, depending on your personal situation. To figure out whether or not you need life insurance, consider its purpose, which is to replace income in the event of the policyholder’s death. If you’re single and have no dependents, nobody is relying on the income you bring in, so you don’t need life insurance.
However, if you’re certain that you want to have a family (and you are otherwise financially healthy—eliminating debt, saving for retirement, etc.), you might take a look at a term policy. By purchasing a policy while you’re young, you lock in lower costs. Further, you can buy a policy before any health problem rears its head and you become uninsurable (or insurance becomes more expensive due to your health problems).
If your salary is important to supporting your family, paying the mortgage, or sending your kids to college, life insurance can ensure that these financial obligations are covered in the event of your death. However, just because you’re not receiving a signed paycheck doesn’t mean
you don’t contribute to your family’s income. If you are a stay-at-home mom, and something happened to you, your spouse is probably going to need some outside help to cover your absence. In 2006, financial guru Dave Ramsey estimated a $300,000–$400,000 policy would be necessary to make up the costs of everything a stay-at-home mom does every day.