Daily Capital

The Difference Between Term And Whole Life Insurance

No one likes to think about it, but at some point we’re all going to die. Just as taxes are inevitable, so is death. While that may not be the best or most desirable thing to think over, the beauty is that you can start planning for it now.

According to LifeHappens.org, there are very few circumstances in which you will not find yourself needing life insurance. That even covers single individuals needing to fund final expenses and/or medical bills.

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Unfortunately, when you discuss life insurance there can be a myriad of opinions that come into play. This largely goes back to the number of options available in the life insurance space and the way some insurance plans are sold.

To be simplistic, there are two major forms of life insurance – temporary and permanent or better stated term life insurance and whole/universal life insurance. Their features, generally speaking, go back to their names. Term insurance is for a given period of time, anywhere from 10 years to 30 years, with 20 year term life insurance being the most common. Term insurance is generally considerably cheaper than the permanent alternative and once the term period ends, your coverage ends. If you pass away prior to the term period ending, then your beneficiaries get the face value of the policy to cover any final needs, etc.

Life insurance chart

Duke University Life Insurance Comparison Chart

Whole and universal life insurance differ from term insurance in that they last for your whole life. With this extended period, premiums are considerably more expensive. Beyond that, the other major benefit whole/universal life insurance offers is that the premiums have the capability of growing as cash value over the life of the policy. This growth is generally tax deferred and can be accessed over the life of the policy, with some catches. However, if you do not touch this cash prior to passing it is then disbursed to your family members in addition to the face value of the certificate.

What Is Whole Life Insurance?

Now that we have a basic understanding of the differences between term and permanent life policies, let’s take a deeper look into whole life insurance. Whole life insurance, as the name states, is insurance that covers you for your whole or entire life.

While premiums will be more expensive than what you will generally find in the term alternative, the premiums do something else for you – they build over time. This will result, if left untouched, in a cash value that will add to the final value of the policy. Unlike some universal life policies which allow for limited equity investing, with whole life policies, these excess premiums are not invested in the stock market, but rather are invested at the insurance company provider’s discretion. This does mean that you will likely be hampered in regards to the return you will enjoy through a whole life policy, but you also get the benefit of having level terms for your life – assuming you hold the policy until passing.

In terms of purchasing whole life insurance, most will be better served by purchasing it at a younger age in order to secure lower premiums. They will still be higher than term insurance premiums, but will be able to lock in a lower premium rate. Those who do wait to purchase whole life insurance at a much older age are doing so in order to solidify the “burial coverage” that most refer to whole life insurance as.

How Is Universal Life Different From Whole Life?

Universal life insurance, much like whole life, is coverage that is considered permanent in nature. You can also build up cash value in a universal life policy like you can a whole life policy. The similarities between the two basically stop there, as we begin to see unique features within their intricacies.

The biggest difference between whole life and universal life is how the premiums are handled and how the excess is managed. With universal life, you can make premiums payments at any time you wish and in any amount you wish – thus pointing to the flexibility they offer. This is why some will refer to universal policies as adjustable life insurance. The important point to remember though is that if you cease making premium payments or withdraw built up cash value it can impact your coverage amount leading up to needing to put more cash in or surrendering the policy, if taken to an extreme.

Assuming you make excess premium payments, which is generally how these products are sold, they go into some sort of investment product. Those investments can be anything from stocks to bonds to mutual funds/annuities but is restricted by what the particular insurance company offers in terms of investment options for cash values. Options vary widely from company to company based off their investment philosophies and what they want to make available to their policyholders, which makes it critical to find a company and policy that aligns with your investing preferences. If you are able to find such a match, an investment-oriented universal life policy provides the potential for a better return than what you’ll see in a whole life policy. Just remember that it also presents greater risk. The other major difference you see with universal policies is that they offer more transparency with regards to fees.

Who Should Buy Permanent Life Insurance?

Whole and universal life insurance have earned a bad reputation over the years as many life insurance agents/companies sell these policies as something they shouldn’t be – an investment. Some of that criticism is well deserved and some of it it’s not. The key to remember is what your personal situation calls for.

Insurance companies base premium amounts on actuarial tables that are weighted by age and health factors. Obviously, the older a person is, the more likely they are to die, which causes the cost of life insurance to be exorbitantly high. Because of this, if you’re older and approaching retirement or are in retirement, then purchasing permanent life insurance likely isn’t going to be the wisest use of your funds. This is especially the case if you’re able to self-insure through other investments and have a way to provide for your family members upon passing and cover your financial responsibilities at death. If that is not the case, then purchasing permanent life insurance is something that could be considered, in addition to looking at viable alternatives such as long term care insurance.

If you’re wanting permanent life coverage, then the best alternative is to purchase coverage as young as you can. While you can still get lower premiums under the term alternative, (where it’s not unheard of to get at least $250,000 of term coverage for $20 per month for a healthy individual under 40) that term will run out. Similar coverage under a whole life plan will easily cost five times that amount, but it also guarantees the death benefit for your entire life. The following sample charts illustrate the difference in premium cost by age for whole life and term life insurance.

Whole Life Insurance Chart

Whole Life Insurance Sample Premium Comparison Chart from AAA of Southern California

Term Life Insurance Chart

Term Life Insurance Sample Premium Comparison Chart from Gaudette Insurance

Again, it all goes back to your personal situation and what fits best.

Lastly, what has become popular amongst older generations in to purchase whole life policies for children or grandchildren. This allows them to lock in lower rates for the recipient while also providing for their future families.

Why Life Insurance Is A Bad Investment

Going back to the problem with permanent life coverage, the issue is when it’s sold as an investment. Having appropriate life insurance coverage is an essential part to proper retirement planning, however, it should by no means be viewed as an investment. This is due in large part because life insurance was never meant to be an investment, but something to enable you to provide for final needs and for your family members once you do pass. The problem comes into play when life insurance companies promote permanent life insurance as an investment and thus play on the naivety of those who’re uninformed about the various options presented with life insurance.

Beyond the misuse of the whole/universal life product, the other major problem behind using permanent life insurance as an investment is that you have no control over how the funds are invested. Yes, you can find a company that might fit alongside your general investment philosophies, but you still have little to no control over how the excess money is allocated and invested. While you can access the cash value, if in need, it comes with a cost. In the event of it being a whole life policy it generally means the lowering of your face value (or death benefit) of the policy.

In the event of trying to access cash values from a  universal life policy, such an action could cause the cash values to go lower than the associated costs and thus harm the policy. That’s also not to mention the fact that any loans taken out against these policies, while tax deferred, do incur interest, which must be paid back. If you’re young that might not be a problem, but many in retirement aren’t seeking to pay back loans on things such as life insurance.

Purchasing life insurance is a personal decision. Don’t allow sales materials to convince you that one item is better over another, but look at what the needs of you and your family are – whether it be investments or life insurance. In the case of life insurance, there are other ways to provide the same benefits you’d receive from a permanent policy, whether that be from purchasing term coverage or simply self-insuring.

Photo: Horseback riding in Cabo, Mexico. FinancialSamurai.com.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

John Schmoll is the founder of Frugal Rules, a blog created to help people experience financial freedom through frugality. John is passionate about budgeting, saving and investing and enjoys sharing his knowledge and experience with others so they can avoid making some of the mistakes that he made. A veteran of the financial services industry, John has an MBA in Finance and experience as a licensed stockbroker. You can follow him on Twitter at @FrugalRules
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