Choosing suitable life insurance is an important financial consideration. Here, we look at the two most common categories of life insurance policy: term life insurance and whole life insurance. Term life insurance protects the life insured for a fixed period, paying out a set amount of money—the death benefit—should the life insured pass away during the term.
A whole life policy, on the other hand, does not have a set term. It remains in effect permanently, paying out its death benefit once the insured passes away. By the end of this article, you’ll have a better understanding of what’s included with each of these popular options and how to choose the right one for you.
Term life insurance is the cheapest life insurance product available on the market. This type of product has a set term, usually 10, 15, or 20 years. As long as you maintain your payments (known as “premiums”), the policy will pay out a specific, predetermined sum of money (called the death benefit) if you pass away before the end of the term.
The best term life insurance policies come with a terminal illness benefit rider included for free with the policy. A rider is an add-on to your existing insurance policy. This rider means that should you become terminally ill (usually with fewer than 6 months left to live), you can withdraw 60-75% of your death benefit. This can be useful to cover any significant medical costs, and it comes standard with many term life insurance quotes.
Unlike a term policy, whole life insurance is a type of permanent life insurance. Permanent life insurance refers to any life insurance without a set term, where the death benefit will be paid out as long as the policy holder keeps making their payments. Since the payout on such a policy is pretty much guaranteed, life insurance companies will charge 5 to 15 times more for the same amount of death benefit on a whole life policy versus a term policy.
Whole life policies also build up a cash value over time, which means you may be able to get some of the money you paid in premiums back while you are still alive. A whole life policy’s premium is split into three parts: the death benefit, which is paid out when you pass; a portion covering the insurer’s costs and profits; and a portion that flows into a tax-deferred savings account—your cash value.
Once your whole life policy has built up a cash value, you can use it to reduce your payments, increase the death benefit, or take out a loan against it. If you do take out a loan, you won’t have to make any repayments throughout your life. Instead, the loan will be paid off with the death benefit.
Finally, permanent policies like whole life can be used as a method of wealth transfer on death. Most assets, such as bank accounts and property, are taxable to the estate of the individual on death. The death benefit of a life insurance policy is not.
As a very simple example, consider a scenario where you pay into a tax-sheltered investment account every year until you pass. This account, including any investment gains, will have tax implications after your passing. Had you contributed the same amount to premiums on a whole life policy instead, the entire death benefit would go to your dependents tax free.
The type of life insurance that is best for a particular insured depends significantly on their situation. Key factors to take into account are budget, life stage, and the amount of income immediate dependents would require to cover costs in the event of the insured’s passing.
Budget is a key factor in determining whether term or whole life insurance is best for you.
A typical 20-year term policy with a $500,000 death benefit costs on average $27/month for a 40 year old. Recall that a whole life policy is between 5 and 15 times more expensive. Thus, the same 40 year old applying for whole life coverage with a $500,000 death benefit could be looking at a premium of $135 to $405 per month.
$27 vs $400 is a huge difference in premium for the same death benefit. So consider affordability first when choosing between term and whole life coverage.
Your insurance needs will change throughout your life cycle. A 20-year-old living alone naturally will not have the same insurance needs as a 40-year-old with a spouse, children, and a mortgage.
However, insurance pricing increases with age, while personal health tends to decline as well. This creates an issue where it is difficult to insure yourself according to your life stage. For a young person with fewer financial responsibilities and likely a lower income, a term policy is ideal. It can provide access to significant coverage on a budget.
As income and responsibilities increase, the flexibility of cash value and stable premiums that come with a whole life policy become more attractive. At the same time, the already expensive whole life policy turns even pricier.
The best way to get around this issue is with a convertible term policy. This is a special type of term life insurance policy that can be converted to a whole life policy at any time before its term expires.
For example, a 20-year convertible term policy would take a 20-year-old to the age of 40, and at that point, they could convert it to whole life insurance. When you convert this type of policy, the insurance company does not check your current health status. Instead, it goes by the original medical underwriting, which would have taken place 20 years before. Since most people are healthier at 20 than they are at 40, this can result in significant savings on the premium of your new whole life policy.
A major consideration when buying life insurance is how much income the heirs would require in the event of the insured’s passing. For example, if the insured earns $50,000/year, and believes that their dependents would require 10 years of income replacement, they will need a policy with a death benefit of at least $500,000.
Knowing how much income you need to replace is an important step in choosing the right kind of life insurance. In the example above, you might find that you can afford a whole life policy for $250,000, or that it is out of your price range for the moment so a term policy is more appropriate.
Term coverage is typically less expensive upfront than whole life coverage at a young age, while whole life has stable premiums, never expires, and gives you the advantage of growing a cash value in your policy.
Which option is right for you depends on your budget, life stage, and the amount of coverage that you need. Generally, you will want to take on as much whole life coverage as you can comfortably afford, then buy the rest as term to make sure that you are fully insured. If you start looking for policies at a young age, you can also take your savings one step further by taking a convertible term policy that you can later convert into a whole life policy.
Now that you’ve seen the benefits of term versus whole life insurance, check out the best life insurance companies to pick a policy that is right for you.