Term Insurance: Not Always the Right Answer

By in Automatic Saving, Guest Post, Insurance, Investing, Reader Question | 13 comments

Your Investing Questions Answered #5

Jeff from Good Financial Cents asks,

“When is whole life insurance a good investment for someone?”

Response by Guest Contributor, Ben Luthi of The Wealth Gospel

In the personal finance world, it is hard to find neutral ground when it comes to life insurance. On one hand, there are some heavyweights who are violently opposed to whole life insurance and will only recommend term insurance. On the other hand, many insurance professionals are quick to tout the benefits of whole life as a long-term goal, regarding the term policy as a temporary placeholder until you can convert to its permanent counterpart.

As a personal finance blogger and a former life insurance agent, I’ve been lucky to hear both sides of the argument, and if you were to ask me which product is better, my resounding answer would be…it depends.

Insurance Basics

Life insurance was first introduced in a rudimentary state during the Roman Empire, but the beginnings of its current form were established in 1760 for the benefit of Presbyterian ministers and their dependents.  Quite simply, life insurance is an income replacement for your dependents if you die while the policy is in force.

There are several varieties of life insurance. The best way to describe the difference between whole life and term would be to compare it with the decision of renting vs. buying a house.

term or whole life insurance which is better

Term Life Insurance Versus Whole Life Insurance

Term Life Insurance

Term is like renting in that you sign up for a specific amount of time. Ten, twenty, or thirty renewable term policies are the general types of term insurance, although there are also annually renewable terms that go much longer. The premium is payable annually although the amount stays fixed for the “term”.

If you buy a 15 year renewable policy for $500,000 of term life insurance your annual premium remains the same for the fifteen year period. And if you die, your beneficiary receives $500,000.

Term insurance is much cheaper than whole life insurance when you are young, but the premiums increase as you get older—slowly at first and then exponentially. There have been many studies done to find out how many term policies actually pay out benefits to policyholders, and the estimates have been as low as 1 percent of policies paid out benefits since people outlived their term or canceled the policy before the term was up.

In sum, term insurance gives you a lot of insurance protection for a small financial outlay.

Whole Life Insurance

Whole life is comparable to buying a house in that it’s much more permanent in nature. The premiums are much higher, but they never increase unless you cancel the policy. There is a 100 percent chance the benefits will be paid out. There is also a cash-value feature, which is where most of your premium goes over the long run. Over the life of your policy, the cash-value acts as a growth vehicle that, like the equity in a home, appreciates with time and can be used as an alternative source for retirement income, or it can be borrowed against at any time throughout the life of the policy.

The difference between term and whole life insurance is that, unlike the value of a home, the cash-value has a guaranteed growth rate which will never be negative, giving policyholders a relatively safe and liquid “investment.” I put that in quotations because it’s more like putting your money in a high-interest savings account than it is investing it in the stock market.

Borrowed funds are tax-free and if you do end up surrendering the policy later in life, you are only taxed on the gains.

Who is a Good Candidate for Whole Life Insurance?

If you were to walk up to me on the street and ask me which product would be better for you, I would tell you term. This may seem to mean that term is better for everyone, but it’s really because I know nothing about you and therefore term insurance would be the safer bet with no background information. For those interested in giving cookie cutter advice, it fits well with their agenda.

Jeff, in answer to your question, these are several situations when whole life insurance is a good choice. Whether it is a good financial “investment” depends upon the investment vehicles it is compared with and their costs. In terms of investing prudence, it’s usually more financially viable to separate out investing from insurance.

So who would be a good candidate for whole life insurance? Here are some different situations when whole life insurance could be a better option than term insurance.

  • Your family has a history of health problems that will most likely affect you and potentially make you uninsurable in the future.
  • You are utilizing tax-efficient retirement vehicles and would like something that provides a tax-efficient and less volatile return that will do better than a savings account or CD.
  • You would like to provide an inheritance for your children.
  • You would like to provide a way to pay estate taxes so that your assets go to whom you choose.
  • You have young children you would like to insure. A friend’s dad bought a whole life policy on him when he was young. He then surrendered it and gave the cash to him as a college graduation present. It ended up being a few thousand dollars.
  • You’re a Dave Ramsey hater. (Kidding!)
  • You aren’t confident in your ability to go the “buy term and invest the difference” route (considering that 58% of Americans don’t even have a retirement plan, this “forced savings” could be helpful).
  • You can afford a long-term commitment to the premiums (If you surrender the policy in the first 10 years, you’re most likely going to get burned).

That being said, some people aren’t in a position to commit to whole life insurance or they just prefer a different method of reaching their goals—which leads me to the next question.

When is Whole Life Insurance a Bad Choice?

Based on my experience and the research I have done, the following situations would make term life insurance a better fit.

  • You need protection but your financial resources are stretched.
  • You only need protection for a short amount of time (i.e. while kids are at home).
  • You are required to have life insurance in order to secure a loan.
  • You are a disciplined saver and would prefer to buy term and invest the difference.
  • You are not interested in locking yourself into a long-term financial commitment.
  • You have large debts that would cause your family financial hardship if you were to die. Thus, it’s cheaper to buy more term insurance to cover the debt.
  • You just don’t like the idea of whole life insurance, which is perfectly fine.

There are certain absolutes that I feel everyone should follow in order to be financially successful, although of course some may disagree. Having insurance to manage the risks to your financial plan is one of them. But I find it hard to ascribe any sort of vehemence toward recommending which products you use to get to where you want to be, because it really boils down to your situation and goals.

One product may be right for one person but completely wrong for another.

The best course of action would be to decide what you want in your future, educate yourself about the different options from different sources, and even meet with a professional who can act as a resource and give you an outsider’s perspective. That way, you will find out what works best for you, and that’s really all that matters.

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Ben Luthi is a personal finance blogger, freelance writer, and the owner of Wealth Gospel (and a former life insurance agent).  He is passionate about helping others align their behaviors with their goals. He’s a chips and salsa connoisseur and his spirit animal is Warren Buffett.

Weigh in, what’s your preference, term or whole life insurance?

image credit; google images_flickr

    13 Comments

  1. Very informative post. All factors should be taken into account when considering Term Insurance. I don’t really like Whole of Life. I decided to take on Term insurance as we have a history of heart problems. Great post, thanks for sharing.

  2. @Nick, We’ve always chosen to buy affordable term and invest on our own. But, there’s no one right solution.

    Barbara Friedberg

    January 23, 2014

  3. Hi Ben, Thanks for the information. My biggest problem with whole life is the upfront sales commissions and other compensation, often totaling well over half the first-year premium for selling these policies. (The figures were excerpted from a WSJ article, titled, Life Policies: The Whole Truth.) This is a huge conflict of interest for me. It pretty much puts insurance salespeople in the same adversarial position as any other sales person who is trying to get me to buy something and separate me from my hard earned money.

    Bryce @ Save and Conquer

    January 23, 2014

  4. I’ve had a term life insurance policy for much of my adult life and can’t see a situation where a whole life policy would fit in with my financial plan. Good comparison between the two types of policies though!

    Paul @ The Frugal Toad

    January 24, 2014

  5. @Bryce
    That is always a valid concern. As a former life insurance agent, I know that possible conflict of interest very well. That being said, I was always very upfront with my clients with how I got paid and made sure they understood that their best interest was mine. I think it’s important to find a life insurance agent whom you can trust, no matter what type of policy you purchase. I met too many people who had gotten crappy cheap term policies that didn’t fit with what they and their family needed because some insurance agent didn’t want to let them go without buying at least something.

    @Paul Thanks! That’s a great example that every person is different. In my mind, there’s nothing wrong with that decision because it’s what fits you best. I would feel the same way if you had said you were whole life all the way because it fits better in your financial plan.

    Ben @ The Wealth Gospel

    January 24, 2014

  6. We purchased term life insurance about 10 years ago and so far it’s still an inexpensive option for us. I figure that when we’re in our mid-50’s, I’ll probably cancel it- but only if we’re financially stable and it’s more expensive than its worth.

    Little House

    January 24, 2014

  7. I had a vague understanding of both types of life insurance, but this really clears things up. Nice example of renting a home vs buying. I am currently on term life insurance and investing the difference in the stock market. Thanks Barb!

    Buck Inspire

    January 25, 2014

  8. @Little House- Great example of personal choice for term. In most cases term is a better option.
    @Buck-So glad this article clarified the concepts. With life insurance, it’s easy to get “sold”. So much better to be an informed consumer.

    Barbara Friedberg

    January 25, 2014

  9. I wish there was a company like Vanguard for the whole/term insurance business! Be sure you read the fine print (don’t take the salesman’s word!) before signing.

    Know what it takes to break a policy. Always take that into account. I see too many people signing up without reading the contract and when circumstances change, learn the hard way it wasn’t what they thought it was!

    Moneycone

    January 26, 2014

  10. @Moneycone-That is excellent advice. I wonder if some of the online insurance companies (where we bought our term) might have similar low cost (high rated company) whole life policies? Does anyone know?

    Barbara Friedberg

    January 26, 2014

  11. This article is excellent, because this is a topic I don’t know much about. It looks like term would be the better option for us. I can’t imagine a situation where I would want to go with whole life. Thanks again for the detailed information.

    Sher@knsfinancial.com

    January 27, 2014

    • @Sher-As you stated, term is usually the best option. You get so much insurance for such a small price, and if you have the discipline to invest on your own through work retirement account(s) etc. term makes better financial sense.

      Barbara Friedberg

      January 28, 2014

  12. @Barbara & @moneycone
    If there is a website out there that offers a similar way to search low-cost whole life, it probably wouldn’t last long. The companies with the best whole life products (Northwestern Mutual, New York Life, Mass Mutual) are generally on the more expensive end, but the reasoning behind it is the more you put into it, the more goes into your cash value. Cheap whole life plans don’t generally do what whole life is meant to do very well.

    @Sher thanks for the comment! I’m glad it helped :)

    Ben @ The Wealth Gospel

    January 28, 2014

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