When you think of life insurance, do you think of your family members getting a payout when you die? Until a year or so ago, that’s all I thought life insurance was. Of course, beneficiaries receiving money upon the death of the insured individual is an integral part of any life insurance product. This is called the “death benefit.” However, there is more to life insurance than that.
For the purposes of this post, let’s discuss the difference between term life and whole life insurance.
Term Life Insurance – How Does It Work?
Term life guarantees a certain amount of death benefit upon the death of the insured if the insured dies during a certain period.
For example, if Mary and Bob are married and Mary took out a term life insurance policy on Bob, it would look something like this: Mary could receive a $500,000 death benefit if Bob were to pass in the next 20 years for a $40 premium payment every month.
The purpose of a term life insurance policy is purely to insure against loss of life, which is why it is sometimes called “pure life insurance.”
“Term and whole life insurance serves completely different purposes. Term should be used for income protection and debt repayment and should typically be used during your working years. Whole life has many uses, including charitable giving, estate planning, final expenses, and tax-sheltered savings”, says Brian So, life insurance adviser and the founder of Brian So Insurance.
According to Brian, “It’s not about term vs whole life. Rather, both can coexist and if an individual has the need, both can form part of their insurance portfolio. For example, a younger individual with a family may need a large amount of insurance to protect his family, which can be covered using term insurance. He also wants to start a whole life policy to shelter his investments from tax, which he can use to supplement his retirement. In this case, he should consider getting both types of insurance.”
The policy premium is based on the insured’s age, health, activities, and life expectancy. Young, healthy people with safe hobbies and occupations will pay lower premiums than older people in poor health with dangerous hobbies or occupations.
Gender plays a part as well, with women being less expensive to insure. Premiums are also dependent on the amount of the death benefit, and higher face values will have higher premiums.
The policyholder will usually choose the death benefit’s amount based on mortgage debt, education savings, consumer debt, funeral expenses, and loss of income.
The Main Types Of Term Life Insurance
One kind of term life insurance is called level-term or level-premium insurance. In this case, coverage is for a specific term (usually 10 to 30 years) and the death benefit and premium amounts are levels throughout. Mary and Bob’s policy from our example is this kind of policy.
Decreasing term policies are another type of term life insurance. The premiums for these policies are level, but the death benefit decreases over time. If Mary and Bob chose a decreasing term policy, their premium would be less than $40 and the $500,000 coverage would decrease over time.
These policies are useful when you consider that the insured is paying down debt, like the mortgage, and saving for education and retirement over time, so the amount of money that would be needed by the beneficiary upon the death of the insured is decreasing over time.
Overall, term life insurance is great for people who only need insurance over a specified term, as their working life, because policy premiums are reasonable considering the amount of coverage the insured is able to receive.
Whole Life Insurance – How Does It Work?
There are two main differences between term life insurance and whole life insurance:
- Whole life insurance provides coverage for the entire (whole) life of the insured.
- In addition to the death benefit, whole life insurance offers a savings component.
A whole life policyholder pays level premiums regularly. These premiums are higher than term life insurance due to the term being the life of the insured and because a portion of the premiums going toward savings. The death benefit is a contracted, set amount.
Whole life contracts are structured in such a way that the cash value will build over time, usually slowly at first. The policyholder can increase the amount of the cash value by paying more extra above the premium for the policy. If the policy pays dividends, those dividends can be added to the cash value of the life insurance to grow on a tax-deferred basis or they can be used to buy more death benefit.
The policyholder can decide to draw on the cash value of the policy in two ways. They can withdraw the cash value (up to the amount of premiums paid without paying tax) or the policyholder can take out a loan.
The policy contract will include how much interest would need to be paid on the loan, however, the policyholder can allow interest to accumulate on the loan and never pay the loan back.
The insurance company will simply pay out the death benefit, less the sum of the balance of the loan and the accumulated interest. In this way, a cash value life insurance policy can act as a lesser substitute for an emergency fund, and more information about alternatives to emergency funds can be found here.
What Happens At The End Of The Term?
If a term life policy is nearing expiration, the policyholder can allow the policy to expire or they could renew the term contract. Some policies allow for renewal without proving insurability, for example, by permitting the insured to forgo a health screening. The premium, however, will increase to match the insured’s current age.
Sticking with the above example, let’s say that Bob was 30 when he and Mary took out the term life insurance policy. As the term is coming to an end, Bob would be nearing 50 years old. His policy may allow him to renew without undergoing a health screening, however, the new premium would be based on a 50-year-old man, rather than the 30-year-old he was when the policy went into effect.
It can seem like you must choose between term and whole life insurance, and if you choose term life insurance that your choices at the end of the policy are either to allow it to expire or to renew the policy. This is not the case, though. Term insurance policies, like all insurance policies, have basic provisions. It is possible to add provisions to insurance policies by means of a rider.
One rider that can be added to a term life policy is called a conversion rider, which makes the policy a convertible term life insurance policy. This rider guarantees the ability to convert an in-force term policy to a whole life policy (sometimes called a permanent policy) without proving insurability. Just like when a term life insurance policyholder chooses to renew for another term, the premium upon converting a term policy into a permanent policy is based on the insured’s age at the time of the conversion.
Which Policy Is Better For You?
There is no easy answer as to which policy is the best choice because term insurance is right for some and whole life insurance is right for others. Term insurance is attractive due to the lower premiums because these policies still offer great coverage for the insured and their beneficiary.
If you can afford the higher premiums, whole life insurance is a great way to save money in a tax-deferred way, while also providing a death benefit to beneficiaries whenever the insured passes away, even if that is decades after the policy goes into effect. On the other hand, many people prefer to save money in a different way and may just want to protect their families with term insurance.
It is important to remember that life insurance offers a way to protect families and businesses in the event of a terrible loss. The worst thing a person with dependents can do is to not make a choice at all because that is in effect choosing no protection and no coverage at all.