After you have determined the appropriate amount of life insurance, you must also determine which type is best for you, both in the short run and in the long run. This decision will have a huge impact on your financial well-being throughout your life.
Term insurance (temporary insurance) has the lowest initial premium but the highest long-term cost because premiums increase over time and your beneficiaries are highly unlikely to ever collect any payout from it. Premium payment terms are very inflexible and you never receive any of your premiums back.
Whole life insurance (permanent insurance) has the highest initial premium but the lowest long-term cost because premiums never increase, and your beneficiaries are guaranteed to receive a much higher payout than what you put into it, as long as the policy stays in force. Furthermore, whole life insurance provides living benefits to you because it builds liquid cash that you can access at any time for any purpose. In the long run, the cash available for you to spend while you are alive is highly likely to be worth much more than what you put into it. Since it builds accessible cash, whole life premium payments count towards your 20% savings goal. Thus, you can accomplish both protection and asset building objectives at once.
The optimum solution would be to own some of each—a prudent amount of whole life insurance depending on how much you are currently allocating to savings, and the rest in term insurance up to your full human life value. Remember that the amount is initially more important than the type. If current cash flow only enables you to acquire term insurance for your full human life value, then just do that for now. Resist the temptation to acquire a smaller death benefit than your family really needs just so you can have some whole life insurance. You can gradually convert portions of your term insurance to whole life later as you increase your savings and eliminate debt.
Some advisors always recommend term insurance and never recommend whole life, emphasizing the initial difference in premiums. They argue that term insurance is a better deal because the premiums are lower. On the surface this may appear to be true, but obviously it does not tell the whole story.
Which do you think would be better for your situation? Why not own some of each like I do for myself and my family, since they each do a great job performing their intended function?
Term Insurance (Temporary)
Advantages
- Premiums are initially much lower than for whole life insurance.
- Great for acquiring a large amount of coverage for a temporary period when money is tight, especially for young families.
- Adequately meets temporary needs such as funding a buy-sell agreement or when life insurance is required for a loan approval.
Disadvantages
- It is very likely to expire before you actually use it.
- It ends up costing a lot more than whole life insurance would have cost if held until the age of normal life expectancy.
- You do not get any of your money back if you cancel the policy before you die.
- Premium payment terms have no flexibility. The death benefit expires after 30 days of nonpayment.
Whole Life Insurance (Permanent)
Advantages
- Death benefit is guaranteed for your entire lifetime, as long as premiums are paid.
- Death benefit increases over time with the payment of dividends, but the premium never increases.
- Eventually you may be able to stop paying premiums and maintain the death benefit for the rest of your life.[i]
- In the long run, you get all of your premium payments back plus a healthy rate of return.
- Builds cash value that may be withdrawn tax-free for any purpose, at any age, during your lifetime.[ii]
- Cash value has built-in guarantees that are not subject to market volatility.
- Cash value may be protected from lawsuit, depending on which state you live in.
- Waiver of premium feature allows your cash value to continue growing even if you cannot work due to sickness or injury for six months or more.[iii]
Disadvantages
- The premium is much higher than for term insurance in the early years.
- The cash value liquidity is low in the first few years. It takes time to build equity.
[i] Depending on the payment of dividends. Dividends are not guaranteed, but are highly likely to be paid.
[ii] We do not provide tax or legal advice. Please consult the appropriate advisor for more information regarding your specific situation.
[iii] There is an additional premium cost when the Waiver of Premium Rider is selected on a policy.
Adam Dawson, CFP® is a Principal at Capstone Capital and the author of Timeless Principles of Financial Security.
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