Whole life insurance and term life insurance are pretty different. Here we'll go over their similarities and differences and pros and cons to decide why you might want one over the other, or neither.
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Term Life Insurance
Term life insurance, as the name suggests, has a specified term length for coverage during which it will pay out if you die. That term could be 20 years, 30 years, etc.
For example, if you buy a 20 year term policy with a $500,000 death benefit and you die within that 20 year coverage window, your beneficiaries get $500,000. Simple as that. If that term coverage ends and you die afterward, beneficiaries receive nothing.
Term life insurance is easy to understand because you are paying for “pure” insurance and there's no saving or investing component. As such, there are no wealth building or tax saving advantages with term policies. This also makes term life insurance significantly cheaper than whole life insurance.
For most term life insurance policies, the premiums and payout stay constant. For example, your policy's hypothetical $500,000 payout and $25 monthly premium will remain unchanged for the entire term. A larger death benefit or longer term obviously means a higher premium.
Ideally a term life insurance policy will cover some specific obligation, such as a 20 year term policy to cover a newborn until she can provide for herself financially.
Term life insurance is flexible based on your desired timeframe, and typically does not require a medical exam.
Whole Life Insurance
Whole life insurance, as the name suggests, is a type of permanent life insurance that lasts your whole life, provided you can pay the premiums.
Whole life insurance costs much more than term life insurance because it lasts longer and has what's called a cash value component that accumulates tax-free as time passes. A portion of your premium goes toward that cash value which can later be withdrawn or borrowed against. Cash value usually doesn't accrue for several years after coverage begins.
The cash value component makes whole life insurance policies a hybrid vehicle with insurance and investing under one roof. As such, whole life insurance is sometimes referred to as “cash value insurance.”
The premiums of whole life insurance policies are typically 10-20x higher than that of term policies.
Premiums for whole life insurance policies typically remain constant and the cash value grows at a fixed rate. Death payouts are also guaranteed, though any loans taken out will decrease the death benefit if the loan is still outstanding.
If you let the whole life policy lapse, you may face surrender charges.
Whole life insurance policies also typically require a medical exam.
All these factors make whole life insurance much more complex and confusing than term life insurance.
Which Is Best for You?
So should you choose term life insurance or whole life insurance?
First we'll go over some quick factors that may easily make the decision for you, and then after that we'll cover the more nuanced considerations of choosing.
Factors for a Quick Decision
Choose a term life insurance policy if you:
- Need coverage for a specific time period, e.g. 20 years.
- Want the cheapest option or simply can't afford whole life insurance.
- Don't care about cash value accrual of whole life insurance.
Choose a whole life insurance policy if you:
- Want lifetime coverage.
- Have a lifelong dependent like a child with disabilities.
- Want a policy with a cash value component.
Now let's talk about some more nuanced considerations when choosing between term and whole life to explain why term is probably the right choice for most people.
Simplicity and Efficiency
First, remember the simple fundamental reason for life insurance in the first place – to replace your income for someone who depends on it. As such, a term policy fits that bill perfectly, as it's simple, affordable coverage for a specified time period and payout. This is just like how other types of insurance work like homeowners insurance, car insurance, etc.
Recall that whole life insurance is much more complex and involves insurance plus a cash value accrual component. Insurance agents count on you being confused by that complexity.
This is also what makes whole life much more expensive than term. For any given coverage amount, we should prefer to get it as cheaply as possible.
I'm not a fan of mixing insurance and investing anyway. Hopefully you've already got an emergency fund, a taxable brokerage account, and retirement accounts like a 401k and Roth IRA already to cover the investing side. Once those grow sufficiently large, you'll no longer need life insurance at all and you will be self-insured, as those assets in those accounts can simply flow to your beneficiaries upon your death.
In other words, insurance is there to provide peace of mind. It should not be viewed as a money-making machine or investment account.
The insurance salesman will almost certainly try to pitch the idea that a whole life policy offers financial flexibility. I would argue the opposite. A whole life policy offers each of its components – insurance and investing – in a less efficient manner than each of those on their own using other account types.
Investment options for whole life policies are limited, and usually to low-returning assets, not to mention fees and expenses along the way that accompany the whole life policy. Simply take the huge savings from a term policy and invest that money in traditional investment accounts however you want to achieve the same thing as a whole life policy but in a more efficient, more effective way.
Lastly on the subject of simplicity, a whole life insurance policy usually requires a medical exam, while a term policy usually does not.
As you might expect, recognize that the insurance salesman gets a much higher commission by selling you a whole life policy. They'll use marketing buzzwords and focus on that cash value component as a benefit, but now you know that benefit isn't really a benefit at all.
Just in case you think the cost difference isn't much, I want to reiterate just how much more expensive whole life policies are than term policies.
On average, for the same amount of coverage, whole life policies are typically at least 15x the cost of term policies. That means a hypothetical monthly premium of $25 for a term policy would be at least $375 for an equivalent whole life policy. Again, if you can afford a $375 monthly premium, simply take that savings of $350 and put it toward your emergency fund and investment accounts.
Let's follow through on this hypothetical example to show just how impactful this difference is.
While we'll make up the numbers for future returns, we can reliably expect a considerably lower return for the cash value component of the whole life policy versus a traditional investment portfolio of stocks and bonds. To be conservative and completely fair, though, we'll generously use a difference of only 4% between those different options, using an expected return of 3% for the former, which is admittedly on the higher end of the probable range, and 7% for the latter. We'll also generously give the cash value component 95% of the premium and ignore the hefty fees and commissions in the first few years of a whole life policy.
Here's how those two different scenarios would play out over 30 years:
|Term Life Insurance||Whole Life Insurance|
The scenario using a term policy results in over double the final value compared to the whole life policy!
But wait, there's more…
Cash Value (Only for the Policyholder)
Lastly, to add insult to injury, the cash value component of a whole life insurance policy is completely separate from the death payout and is thus only available to the policyholder, not the beneficiaries. That means if the policyholder has a $500,000 whole life insurance policy that has also accrued $100,000 of cash value over the years, beneficiaries will only receive the insurance payout of $500,000 if the policyholder dies without withdrawing the cash value.
You're probably wondering what happens to that other $100,000 of cash value. The insurance company keeps it. If that sounds like a scam to you, it's because it is.
Linking this to our previous example, that accrued value in the whole life policy is $207,588 is entirely forfeited if the policyholder dies without using it. This fact alone should make you run from whole life policies.
To recap, here's a comparison table for term life insurance vs. whole life insurance:
|Feature||Term Life Insurance||Whole Life Insurance|
|Coverage period||Typically sold in increments of 5 years, e.g. 5, 10, 15, etc.||Whole life|
|Payout guaranteed||During coverage period as long as you pay your premium.||As long as you pay your premium.|
|Cash Value||None||Yes; cash value grows at set rate.|
|Medical Exam||Typically not required||Typically required|
Term life insurance is much more affordable than whole life insurance. Unless any of the very unique financial needs mentioned above apply to you, a term policy is probably going to be the better choice.
Insurance and investing should be viewed separately. An insurance policy is not a savings, investing, or retirement plan.
One can simply take the savings on premiums and invest that difference in traditional vehicles and assets such as index funds within a 401k or IRA. Moreover, once those assets grow sufficiently large, you are effectively self-insured and probably don't need life insurance at all.
Ready to consider a term life insurance policy? Get a free quote from Everyday Life here.
Do you have a term life insurance or whole life insurance policy? Are you considering buying one? Let me know in the comments.
Disclaimer: While I love diving into investing-related data and playing around with backtests, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.
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