Share This Article
As soon as you make the decision to purchase a life insurance policy, you immediately come to one of the most important crossroads in life. All market segments are divided into two main types of insurance: Term Life Insurance and Whole Life Insurance.
Both kinds of insurance are supposed to pay a financial cushion to your family members in case of your death. However, the principles of these products are drastically different. A wrong choice can result in huge financial losses and leaving your loved ones unprotected in terms of finances at their most vulnerable time.
Term Life Insurance: Pure Protection
Term life insurance represents one of the simplest and cheapest life insurance products. It is called pure protection since it is dedicated solely to covering risks and does not imply any complicated investment and cash value components.
How Does It Work?
When entering into a term life contract, you determine two basic parameters: the total amount of death benefit and the period for which you need protection (term). The standard choices are 10, 15, 20, or 30 years.
Level Premium: Monthly or yearly premium stays constant through all the term.
Expiration: If you die during the term of insurance, all the money go to your beneficiaries in full tax-exempted. If you survive the term, then the policy automatically expires, and the company keeps all the premiums you have been paying through the years.
Key Advantages
Excellent Affordability: Since it is a temporary policy that pays only in case of your death within the selected term, it is extremely cheap. A person in their 20s or 30s can buy a $1 million safety net spending less than on a monthly subscription to a streaming platform.
Strategic Timing: You can perfectly adjust the period of protection depending on your needs. If you need to cover a new home mortgage, you can purchase a 30-year term; if you want to protect your children until they finish university and become independent adults, a 20-year term would suit better.
Whole Life Insurance: Permanent Investment
Whole life insurance is a type of permanent insurance policy. In other words, the product is supposed to serve you throughout your whole life, from the moment you signed the contract until you passed away, assuming that you have been paying premiums regularly.
How Does It Work?
In addition to the basic coverage, whole life includes an element called cash value.
Premium Splitting: Each time you pay a premium, the company divides it into two parts: one part covers administrative expenses and death benefits, and the second one is credited to the cash value of your contract.
Tax-Free Growth: The cash value grows gradually at a guaranteed rate established by the underwriting company and remains exempted from annual taxes. You are entitled to take money out of this fund in form of loans to finance your retirement or purchase a business or educate your kids.
Key Advantages
Guaranteed Payout for Life: Since the policy lasts throughout your whole life, you are mathematically guaranteed to get a payout to your beneficiaries, provided that you keep paying premiums.
Liquidity: The cash value gives you an additional opportunity to withdraw money for yourself while being alive, without going through credit checking and bank loans.
3. The Financial Trap: Cost Disparity
The most important thing that you should consider when purchasing insurance is a difference in premiums. Whole life policy is much more expensive than term life policy for the same level of coverage due to its guaranteed payout.
Suppose you are a healthy 30-year-old individual who wants to buy a $500,000 life insurance policy:
A 20-year Term Life policy might cost you about $25-$30 per month.
A Whole Life policy may cost you around $250-$350 per month for the same $500,000 of coverage.
Such a significant difference means a dangerous financial pitfall. Since whole life policy is too expensive, people tend to buy smaller policies, such as $50,000 or $100,000, to fit the monthly premium into their budget. Such an amount will hardly be enough even to cover funeral expenses and a few months of rent in case of an unexpected death.
4. The Smart Move: “Buy Term and Invest the Difference”
For the majority of standard consumers, the best way to grow your wealth is to separate investments from protection. This method is called “Buy Term and Invest the Difference”.
Instead of entering into a costly $300/month whole life policy, you can split your actions into two steps:
Purchase a cheap but powerful Term Life insurance for $30 per month in order to protect your family in the years when you still have debts and young children.
Use the saved money, $270 per month, to invest in low-fee index funds, retirement accounts, or other ways of making money.
Since historical average returns on broad market index funds are much higher than the ones offered by the cash value, by the time your term life policy expires, your kids will become adults and you will have accumulated a considerable sum to finance their education and living.
Final Strategy: Conclusion
Think about your goals in life and choose the best product to achieve them:
Purchasing Term Life Insurance would be the most appropriate choice if your key priority is protecting your family. You can provide them with maximum protection during those decades when you still have mortgage, car loans, and young kids.
If you are a wealthy individual who has already used all your traditional ways to save and invest money, such as retirement accounts, and need estate planning solutions to avoid taxes on inheritance, then Whole Life Insurance would suit you perfectly. You can also choose this type of insurance if you have a lifelong dependent who needs to be provided for.
Frequently Asked Questions (FAQ)
Question: Can I convert Term Life Insurance into Whole Life Insurance?
Answer: Yes, the vast majority of modern term life insurance contracts contain a clause called Term Conversion Rider. Using this option, you can convert a certain part or all of your term life insurance into a permanent whole life product skipping the medical examination process. This is useful in case you develop some chronic disease that would make you pay high premiums for a whole life policy.
Question: What happens if I can no longer pay high premiums on Whole Life Insurance?
Answer: In case you face a financial crisis and skip payments, your whole life insurance policy becomes inactive after some period of time. Nevertheless, there are several opportunities to avoid total losses. You can either surrender your policy and cash out the money you have paid (with surrender fee) or use your cash value to pay premiums automatically via a policy loan. Another way is to convert your contract into reduced paid-up policy that would provide you with smaller but still permanent death benefit, with no more premium obligations.
Question: Is the Cash Value Paid Out Together with Death Benefit?
Answer: No, this is one of the biggest misconceptions about whole life insurance. In case of a death, the company pays only the death benefit to your beneficiaries, while the cash value of your contract goes to the company. The whole idea of cash value is that it should give you liquidity during your lifetime, that is why withdrawing the money from cash value would help you benefit from it.