Life Insurance: What to Consider When Looking for Coverage
On this site, we’ve discussed a number of what I’ve called “money milestones” that tend to be celebratory achievements. We’ve also covered the benefits of several different types of insurance ranging from the popular (namely health and auto insurances) to the underutilized (like renters insurance). Well, today I wanted to look at a milestone that coincides with a less joyous occasion and type of insurance that’s not only often overlooked but is also fairly awkward to talk about: life insurance.
It’s true that the mere thought of life insurance is uncomfortable. Yet, ironically, its very purpose is to make financial life comfortable for your loved ones after you’re gone. Thus, while it may seem occasionally callous to mix money matters and mortality, it’s time we take a blunt look at life insurance, including the benefits, the differences between term and whole life insurance, and more.
Why purchase life insurance?
Before we dive into the difference between term life and whole life insurance policies, it’s important to comprehend the basic benefits of life insurance. Simply put, the idea is that life insurance policies will provide your loved ones with financial stability in your absence. While this might lead some to assume that only couples or those with children might need policies, the truth is there are plenty of reasons why one might consider a life insurance policy.
In some cases, individuals might choose to purchase a small policy, enabling their surviving family to cover your funeral arrangements, any outstanding debts you may have, and other expenses. Meanwhile, others might consider a policy with a much larger “death benefit” that will effectively replace their income for as long as they see necessary. The point is that the amount of coverage, type of coverage, and length of coverage you choose can vary greatly depending on your situation and that of your family. With that, let’s take a look at how term life and whole life policies work.
Understanding Term Life Insurance
What is Term Life Insurance?
The premise of term life insurance is simple: you pay a monthly premium for a policy that expires after a certain period of time (typically between two to 30 years). If you were to pass away during that time frame, barring a few exceptions, your selected beneficiaries would receive a payout. In the event that your policy expires and you’re still alive, no payout is provided and you’ll need to shop for another policy if you’d like continued coverage.
Because term life insurance policies have set end date and can often expire without a payout being made, they are typically less expensive than whole life policies. As a result, these types of policies tend to be popular among those who either need only temporary coverage or perhaps want to have peace of mind now but aren’t quite ready to purchase a whole life policy. Furthermore, in many cases, policies with shorter term lengths tend to offer lower monthly premiums than those that last longer. To that point, companies like Bestow even offer term life policies as short as two years, allowing individuals to obtain affordable coverage without entering into a long-term commitment. In fact, these policies start as low as $2.50 a month.
One downside of term life policies is that some providers may have age limits on who can purchase policies. Because of this, those who are looking for coverage into their later years may want to look into whole life policies.
Who is Term Life Insurance Best For?
Term life insurance may be a good option for those whose untimely death would have a negative monetary impact on their loved ones but who don’t feel the need to retain coverage beyond a certain timeframe. For example, if you have elementary school-aged children and want to ensure that they can afford to go to college regardless of whether you’re around or not, you might consider a 20-year term life policy that would only expire after they’ve (hopefully) completed their schooling. Speaking of schooling, a young couple working to pay off student debt might also consider term life policies so that the surviving partner is able to cover these obligations if the other should pass.
How Much Term Life Insurance Should You Purchase?
Obviously this is a question in which the answer will vary for each individual, couple, and family. That said, some financial experts have offered some rough equations to help you figure it out. Famed financial guru Dave Ramsey suggests term life policies should equal 10 to 12 times your annual salary. However, he does note exceptions to this rule such as those who expect to be making far more per year in the near future. Since term lengths are locked in, it likely makes sense to base your policy on your upcoming salary number instead.
Even with those adjustments, there are still plenty of other factors that can affect how much term life insurance you purchase. That’s where the DIME method of calculating your policy comes in. In this case, DIME stands for debt, income, mortgage, and education. Under this method, you’d not only calculate your 10x income but also add in any outstanding debt (including your mortgage), the expected costs of having your children pursue higher education, and other expenses such as funeral costs to determine your optimal coverage range.
Lastly, you’ll also want to consider taking out term life policies for both partners — even those who are stay-at-home parents. That’s because, while they might not have any direct income, you might need to pay for child care in their absence or even leave your current job in order to help out at home. Again, while these are unpleasant things to think about, it’s important to consider these possibilities when determining what coverage might make sense.
Understanding Whole Life Insurance
What is Whole Life Insurance?
Unlike term life insurance that ends at after a set time frame, whole life insurance covers you until you either cancel your policy or pass away. This concept might sound simple enough, but whole life policies are often far more complicated than they seem. That’s because whole life insurance policies also include either a saving or investment component. Furthermore, there are similar types of permanent life insurance — including universal life insurance, variable life insurance, and variable universal life insurance — that only add to the list of options.
In terms of premiums, the good news is that your rate will stay the same for the life of your policy. At the same time, whole life policy premiums are often far higher than term life policies, not only because they offer a guaranteed payout but also because of the savings element. Because of this, some considering coverage might look to term life options first before eventually moving to a whole life policy.
The “cash value” of whole life policies
One reason that whole life policies have much higher premiums than with term life is that only a portion of these payments go towards your actual coverage while the majority accrues in what is essentially a savings account. These funds are known as the cash value of your coverage and grow at varying rates depending on your policy.
Policyholders do have a few options for what to do with their cash value. For one, they can borrow against their policy’s equity and use the funds as they see fit. However, these loans will incur interest and, should you die before the loan is repaid, the outstanding balance will be deducted from the benefit payout.
Another option you have for claiming your cash value is surrendering your policy. This means you will be canceling your coverage, so no death benefit will be paid afterward. Additionally, depending on your policy, your cash value may be subject to surrender fees.
So, finally, what happens to your cash value should you retain your policy and pass away? Contrary to what you might think, this cash value is not paid out to beneficiaries after you die. Instead, only the face value — e.g. the death benefit coverage amount you selected for your plan — is paid. As you’ll see below, this is one aspect of whole life policies that some have taken issue with.
Arguments for and against whole life
As it turns out, whole life insurance is actually a fairly controversial topic among financial experts. On the one side, you have those that compare term life insurance to renting and whole life insurance to owning and, thus, building equity. Meanwhile, good ol’ Dave Ramsey has argued that whole life insurance is a rip-off, advising that those in need of life insurance stick with term.
Starting with Ramsey’s arguments against, he notes the price discrepancy between whole and term life insurance products that he cites at 20:1 (the ratio may not always be that high but whole life premiums are undoubtedly higher). Furthermore, Ramsey points out that only the face value of a whole life insurance policy is paid to beneficiaries while the cash value is not. Because of this, he’s called whole life insurance policies “one of the worst financial products in the world” and even “the payday lender of the middle class.”
Despite Ramsey’s harsh words for the whole life insurance market, there are those who say he’s ignoring the benefits of such policies. Proponents of permanent life insurance policies suggest that they offer a lifetime of protection in so much as they guarantee a payout upon death while also building equity that can be tapped in times of need. Plus, as they note, your payments remain the same throughout your life, whereas renewing a term life policy might result in a rate hike — or even ineligibility.
In the end (no pun intended), it’s up to you to determine which side of the debate you find yourself on. In any case, it’s always a good idea to look critically at any policy you may be considering purchasing and make sure you fully understand what you’re buying beforehand.
Who is Whole Life Insurance Best For?
Ultimately, the first question to ask when determining if whole life insurance is right for you is, “can I afford it?” Regardless of what you think of Dave Ramsey’s rants against whole life, it’s hard to deny he’s pretty much right in regards to how much more these policies cost each month. Even if most of these payments are going into a savings account or investment product, you’ll still need to pay this money out of pocket each month.
A popular use for whole life insurance policies is to assist those whose heirs might be subjected to estate taxes. Since life insurance payouts are tax-free, these funds can be used to help cover any estate taxes that may be due. Additionally, whole life insurance policies can be used to add to inheritance gifts without increasing the tax burden.
Finally, there may be those that might want their spouse to receive payment regardless of when they pass away. With term life insurance, their policy may expire at a time when they are no longer able to renew their policy, leaving them without options. Thus, those who want a guaranteed payout might look to whole life insurance policies instead.
Planning for your own death is never fun. That said, as the number of loved ones depending on you increases, the time may come to consider purchasing a life insurance policy. Whether you decide that a term life or whole life policy is right for you and your family, what’s important is that you find a plan that meets your current budget as well as your future needs.
Also published on Medium.