If you’ve ever bought life insurance you’ve been faced with the decision to either buy a permanent (cash value) or term policy. Sometimes the decision isn’t easy. Especially, if you’re not familiar with life insurance products.
I started thinking about these two different types of life insurance policies again when I recently received a letter in the mail from my insurance provider. The letter was informing me I had the option to convert to a permanent policy from my 20 year term insurance. Along with stating the benefit was like owning my policy there were some other benefits mentioned:
- Lifetime protection
- Builds equity over time
- Cash value accumulates tax deferred
- Cash values can be accessed for emergencies, opportunities, to pay policy premiums
- Supplement retirement income, pay for long-term care, provide for an inheritance or to pay estate taxes
What is the difference between whole life and term insurance?
So, what is the difference between these two types of policies, anyway? I have David Bach’s Smart Couples Finish Rich: 9 Steps to Creating a Rich Future for You and Your Partner in my personal finance library and remembered it had a pretty good section on insurance and especially with describing the differences between term and cash value life insurance. Here’s a summary of what it says:
Term Life Insurance
Term insurance is when you pay a company a monthly premium and the insurance company pays your beneficiary a benefit when you pass away. Term insurance provides you with a set amount of protection at a set price for a set period of time. The advantage is that it’s cheap, but the disadvantage is it doesn’t build a cash value. Once you decide you no longer want the coverage you walk away with nothing.
There are a couple types of term insurance.
- Annual Renewable: Your death benefit is the same, but your premiums get larger each year because there is an increased risk of you passing away. The benefit is that it’s really cheap when you’re young.
- Level Term: Both the death benefit and the premium remain the same for the period of time you selected when you purchased the insurance.
Permanent or Cash Value Life Insurance
Permanent life insurance is basically combining a term policy with a forced savings plan to help you build a nest egg or emergency savings you can use if necessary. Some people use the savings to eventually pay their monthly insurance premiums [as suggested in the letter I received]. The important thing to keep in mind is permanent insurance is a lot more expensive than term life insurance. According to Bach, permanent insurance can cost as much as 5 or 10 times as much as term insurance.
There are different types of permanent insurance important to mention. Here is a quick run-down:
- Whole Life: It’s much more expensive than term and your savings is placed in a money market account that seldom earns no more than 4-5 % per year (according to Bach).
- Universal Life: Same as above, but the insurance company invests your premium for you typically promising great returns.
- Variable Universal Life: You control how you invest your savings portion of your premium with different funds that are offered.
Which life insurance is right for you?
Bach says you should consider term insurance if you’re not buying life insurance as an investment and says in most cases this isn’t what you should be doing. He also gives some good tips on when you should consider a permanent or cash value policy:
- You want to build cash value for retirement
- You have at least 15 years to invest in the policy
- You earn a high income (at least $100,000 per year)
- You are already maxing out contributions to a qualified retirement plan
- You understand the risks associated with mutual funds
Dave Ramsey also has an opinion in his The Money Answer Book on choosing between the two types of life insurance.
I would buy term insurance (10 times your income if you have a child). The savings portion of a whole life policy is a total rip off. The interest paid on it only amounts to 2-3 percent.
There are a few other reasons why Dave prefers term life insurance which I found on his new Dave Ramsey Answers iPhone app.
The big problem is that, when you die, with the savings insurance, they keep your money. They will give your beneficiary the check for the face value and keep the savings for themselves. Cash value is the biggest middle-class ripoff with the exception of maybe the car lease and the credit card. You could put your money in a fruit jar and it would do better than this insurance!
Yes, Dave does have a way with words, doesn’t he?. Essentially, Dave is recommending people buy the inexpensive term insurance and invest the difference somewhere else to where you have more investment options and can potentially get greater returns. One of Bach’s recommendations is also important here. He states you should max out contributions to a qualified retirement plan first. In other words, don’t let your life insurance fund your retirement.
Will we switch from term to permanent life insurance?
Overall, I don’t think permanent life insurance is a fit for our family primarily for the reasons provided by Dave Ramsey. Also, I couldn’t imagine my premiums increasing by as much as 5-10 times as Bach states. There just isn’t any room in my budget for that type of increase. But, if there was, I would prefer investing in some mutual funds in which my family could fully inherit upon me passing away.
So, what about you? Would you switch to permanent life insurance? Do you have permanent life insurance today? If so, what were the reasons you felt this was the best choice for you?
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