February 28, 2011
Frank from Frederick, MD:
What’s the difference between Term Life insurance and Whole Life insurance? Which should I choose?
This is a very common question. Please keep in mind that we are not insurance agents. As usual, we’ll try to take a crack at answering the question anyway!
The basic difference is that Term Life is a simple life insurance policy that pays a benefit if the insured dies during a specific period of time (the “term”). Common Term Life policies are for 10, 20, or 30 years. Whole Life policies generally don’t’ have an expiration corresponding with a “term” and also incorporate some type of investment component as well. The premiums for both policies are generally fixed for the entire the policy. Term Life insurance is much less expensive because it is only a death benefit (no investment) and only covers a specified term. Generally both types of policies have premiums paid using after tax dollars, and thus the benefits are paid tax free as well.
The investment component of a Whole Life policy can be based on a fixed rate, a floating rate, or can be linked to something variable like a broad stock market index. Because a Whole Life policy combines life insurance and investment components, it can sometimes be more difficult to evaluate the investment performance by itself. They often carry more expensive costs, which detracts from the ultimate investment returns, compared with simpler investment vehicles. In some cases, the investment returns are back-loaded, requiring the investor to hold the policy for a very long time to reap the benefits of the investment.
Some investors like the forced discipline of paying the Whole Life insurance premium every month, which in turn creates savings in the form of the investment component of the policy. We generally prefer a Term Life Policy and a separate savings/investment account using simpler, more cost effective instruments.
Most people really only need life insurance if they have dependents. Some may consider small policies to cover funeral costs if there is no money in one’s estate to cover such final expenses. Generally, however, life insurance is meant to cover the future living expenses of those dependent upon us currently (spouse, children, and dependent relatives).
The size of our insurance needs changes over time. For example, a young family, spouses age 30, two small children, with little savings, probably needs material insurance. A retired couple of age 65, with adult children, and ample savings (hence they are retired) may no longer need life insurance at all, since they have enough savings to cover their future expenses already.
A Term policy is often very inexpensive to buy, but VERY expensive to renew in say 20 years when it expires. So, give careful consideration to not only how much insurance you may need…but how it will change as you age. Many people choose to have more than one policy with different terms (e.g. some 30 yr, some 20 yr, some 10 yr) so they are covered for a long enough time, but don’t carry as much coverage as they approach retirement. The downside of that strategy is that having two identical policies generally costs more than having one policy with twice the coverage.
Since a Whole Life policy is covering for one’s entire life, the cost of insuring you when you are much older (and may no longer need insurance) can be significant. This is one of the other reasons to consider using Term Life insurance and investing the difference for the long run.
As always, you should consider your specific circumstances before making your decision and consider consulting your own financial advisor.
Here’s a nice article on the topic as well, from Smart Money.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
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