Life insurance is one of those touchy topics. No one relishes thinking about their own death. And when you mix death and finances together in one conversation? Well, let’s just say that’s one chat most people would rather sidestep. And indeed, they do—sometimes for much longer than they should.
Most financial advisors view life insurance as an essential component of a comprehensive financial plan. So why do people avoid buying it? Apart from our natural squeamishness about death, some people believe they’re too young to need life insurance. Others just don’t want to pay for it. I get it. Insurance payments are sort of annoying to make—until you need to file a claim, of course. Then you’re likely to be glad you spent the money. But many people forestall buying life insurance because it’s confusing stuff. There are a bunch of different kinds and it’s not always clear which type(s) you need. Certain forms of life insurance are more important, depending on the stage of life you’ve arrived at. So, let’s shine a light on the subject. Then, you can decide whether life insurance should be part of your financial plan and if so, select the best life insurance policy for your needs.
Term Life Insurance: Plain and Simple
Term life insurance is kind of like renting a home. As long as you make monthly payments to your landlord, you get the protection of a roof over your head. If you stop paying rent, your landlord will kick you out and all the money you spent on rent is irrecoverable. That’s the most important thing you need to about know term life: it only has value for as long as you pay your premiums. And it only pays out when you die. The amount it pays is called a death benefit— which is kind of an oxymoron if you ask me.
You might ask, why do I need any money if I’m dead? Well, you don’t, but the people you care about might. When you purchase a term life policy, you select your beneficiaries: most often, the people who rely on you and your income to get by. If you have a life partner, children, or elderly parents who depend on you for support, buying term life insurance is a way to ensure they’re taken care of when you die. The amount of insurance you buy—how large a death benefit you select—will correspond to what it will take to keep them financially secure.
Term life policies come in two flavors: renewable and level term. Renewable plans are short-term. You renegotiate them every year or couple of years. With renewable life insurance, your premiums will gradually increase as you get older. They may rise suddenly if your health declines. But with a level term policy, you pay the same pre-determined premium as you get older. Your rate won’t change if you fall ill. Level term policies let you lock in a rate for a specified term, sometimes for as long as 35 years.
Level premium policies can make budgeting easier. You have just one number to deal with for as long as your policy is in place. That sounds like a pretty good deal, right? But there’s one disadvantage to level premium policies. While you’re young and in good health, you’ll pay higher premiums than you would with a renewable policy of the same size. But if you intend to keep your policy long-term, level premium policies do have a lower lifetime cost. Keep in mind that if you buy a level premium policy, the younger you are, the lower rate you’re able to lock in.
Whole Life: Like a Savings Account Plus
What’s the difference between term life and whole life insurance? Both types of policy include a death benefit. But term policies only have value when you die. Whole life policies, on the other hand, gain value—known as their cash value—as you continue to pay your premiums. That cash value is an asset you can access while you’re still alive. To return to our renting-versus-buying a home analogy, whole life is more like buying a home. With each payment you make against your mortgage, you build equity in your home. Similarly, when you pay your whole life policy premiums, you’re creating equity in your policy. Life insurance companies break your payments up into three parts. One portion goes to the company’s profit of course. One is allocated to paying your death benefit. The third part adds to the cash value of your policy. That’s the “equity” part.
Whole life insurance is akin to a savings account. The cash value part of your policy earns interest. Life insurance companies generally invest the cash value portion of your policy conservatively, so it may not earn a lot of interest. But it may earn more than a traditional savings account would yield. Unlike savings account interest, your whole life interest rate remains constant and is guaranteed for the life of your policy. The interest you earn may be tax-deferred and some whole life insurance policies pay dividends. You can cash your whole life policy in at any time or you can borrow against it. You can even borrow against it to pay your premiums, but that’s a slippery slope. Do that for too long and you can erase the cash value of your policy. At that point, the amount you’ve borrowed is considered taxable income by the IRS. Nonetheless, whole life insurance can weave a safety net for you, as it continues to protect your beneficiaries. One other note on cash value: it’s a living benefit only. When you die, your insurance company will absorb the cash value of your policy. Your beneficiaries receive the death benefit you select when you first take out your policy.
Whole life policy premiums are level for as long as you pay into them. But because your risk of dying increases as you age, the portion of your premium that goes toward funding your death benefit also increases with time. Your policy gains value more quickly when you’re young. That’s a good argument for taking out a whole life policy early in life. In addition, if you aren’t particularly disciplined about saving money each month, that premium bill that arrives in the mail each month can be just the reminder you need to put aside a little money every month.
Universal Life: A Hybrid Solution
For some people, universal life, also known as adjustable life, is a best-of-both-worlds choice. Like whole life, a universal life policy gains value over time. You can also borrow against it. But adjustable life policies also offer some of term life’s flexibility. You can adjust your death benefit periodically to raise or lower you premium and protection periodically. It’s easy to imagine why you’d want to lower your premium, but the advantage of reducing your death benefit is a little less obvious. Let’s say you took out your policy when your children were young. You needed a policy that would not only fund their basic needs, but also their college education. But you live long enough to see them grow up. They’re capable of taking care of themselves. That large death benefit may not seem so necessary anymore.
Is Life Insurance Worth the Cost?
If you’re young and healthy, the cost of term life insurance can be truly nominal. Less than you’d spend for a month’s worth of lattes at Starbucks. If you plan ahead, create a budget, stick to it, and start setting aside some money you’ll be solid. If you have dependent children, consider term life insurance the cost of the privilege. Losing a parent is devastating enough. You don’t want to layer financial insecurity on top of that. Whole life insurance is more expensive than term, and universal life often falls somewhere in the middle. What type of insurance you choose will depend on your life stage, your overall financial goals, and your budget. But you don’t need to figure it all out on your own. A licensed insurance agent can talk you through multiple scenarios and help you analyze which type of policy or policies make sense for you.