Buying life insurance sounds like a complicated decision, but most people can start shopping by making a simple comparison: term life vs. whole life insurance.
Term life insurance is simple and offers coverage for a specified time period. Whole life insurance is more complex and offers coverage until death.
Money expert Clark Howard likes term life for most everyone. In this article, I’ll explain how term life and whole life insurance are different, I’ll compare the costs and I’ll give you the information to help you decide what’s right for your financial situation.
What Is Term Life Insurance?
Term life insurance provides coverage for a specific period — usually 10, 20 or 30 years. Your beneficiary will receive a “death benefit,” or payout, from your insurance policy if you die during that term.
Sometimes called “pure” life insurance, term life insurance holds zero value unless you die. It’s only life insurance. It does not include any sort of investment component.
Term life insurance premiums, which is what insurance companies call your monthly payments, are much cheaper than premiums for whole life insurance.
When you buy term life insurance, your biggest decisions are how long of a term to purchase and the amount the policy would pay out. Keep in mind that life insurance is designed to replace your expected income and protect your family if you die prematurely.
There are a lot of questionnaires and calculators to help you decide. But the bottom line is that you want to pick a term and an amount that will make sure that your spouse, children or other dependents remain financially secure if you die.
What Is Whole Life Insurance?
Whole life insurance offers you coverage for life. It’s permanent.
Your beneficiary will receive a payout when, not if, you die. Keep in mind you must pay the fixed-price monthly premium as long as you live.
Like term life insurance, you and your insurance company will need to agree on the amount your beneficiary will receive when you die.
The premiums are much more expensive than those for term life insurance. That’s because whole life insurance includes an investment component known as cash value.
Explaining How Cash Value Works
The details of each whole life insurance policy’s cash value differ. But generally speaking, they’re laced with fees and provide a low return on investment. Even worse, when you die, your family gets only the death benefit, and the insurance company keeps the cash value.
A whole life insurance policy works a bit like a mortgage: During the first few years, a large portion of your payments during the early years goes toward interest. More of your monthly payments go toward the principal as you get closer to paying off your house.
With a whole life insurance policy, a higher percentage of your premium goes toward cash value when you first buy it. When you’re older, a higher percentage goes toward the actual insurance.
There are a few ways you can capture the cash value and prevent it from being a large, pointless payment to your insurance company. You can take out a loan against the cash value. You usually can use your cash value to pay for your premiums later in life. And you can surrender or cancel your policy and get back a percentage of your account’s cash value from your insurance company.
The problem is, unless you’re a modern-day Nostradamus, it can be difficult to predict your own death. So the odds are on the insurance company’s side. Given a volume of whole life insurance policies, the insurance company will make a nice profit and a number of people will end up forfeiting all their cash value to the company.
If you do manage to tap into your cash value, you’ll often pay fees or not be able to collect the full amount.
Term Life vs. Whole Life Insurance: Comparing Features
Term life insurance is simple, while whole life insurance is complicated.
But it’s easy to explain term life vs. whole life insurance.
- Term life insurance offers cheaper monthly premiums.
- Whole life insurance will pay out no matter when you die, while term life insurance will pay out only if you die within the specified term.
- Whole life insurance includes an investment element called cash value.
Term Life vs. Whole Life Insurance: Comparing Cost
The chart below provides monthly price comparisons between term life and whole life insurance as of September 2020. I used 20- and 30-year term life policies because they are among the longest coverage periods and therefore the best comparison to whole life.
For term life, I averaged the monthly rates provided by Policygenius and Haven Life Insurance Agency for males and females at 25, 35 and 45 years old who are in good health. (The other options were excellent health and average health.)
For whole life, I used monthly rates provided by USAA for males and females of the same ages. I set the height and weight at 6’ and 180 pounds for the male and 5’8” and 150 pounds for the female. I selected no military background, no tobacco use in the last 12 months, no parent who died of cardiovascular disease before 60 and no history of medical conditions that required care from a doctor.
|20-Year Term Life
|30-Year Term Life
A Practical Example
Take a look at the third example in the table above. A 35-year-old female with a $1 million policy ends up paying $492 annually for a 20-year term life policy or $7,524 annually for a whole life policy. That’s a difference of $140,640 in 20 years.
If she invested that money and got a 10% annual return (the approximate average for the S&P 500 since it formed in 1926), she’d end up with $402,757.80. Remember, her beneficiary would still get the $1 million death benefit if she were to die during the 20-year term.
With whole life insurance, her insurance company would take a chunk of her premium for commissions and fees. The remaining portion would grow but at a rate that’s historically much lower than the average of the S&P 500.
And if she died before finding a way to leverage that money, her beneficiary would get a $1 million payout, but the insurance company would keep every penny of her cash value.
Term Life vs. Whole Life Insurance: Which Is the Best Choice?
Term life insurance makes more sense for almost everyone, according to Clark.
If you’re wealthy, there may be some tax implications that make a whole life insurance policy attractive. The IRS does not tax the cash value of a whole life policy as it accumulates; it’s tax-deferred. You can also borrow money, tax-free, from your cash value up to the amount you’ve paid into the policy.
You could also see the policy as a way to stash away cash for something you might need later in life such as long-term healthcare policy that could pay for nursing home or home healthcare.
For everyone else, the monthly premiums can be prohibitively expensive. Some people even end up abandoning their whole life insurance policies even though they’ve paid thousands in premiums over the years.
One also has to consider that, for most people, investing on your own will provide a better return than using whole life insurance as an investment vehicle. According to Clark, a Roth IRA is a much more efficient way to save money for the future.
A Simple Guide to Making Your Decision
Here are the things you should consider to make your choice.
Choose term life if:
- You don’t want to worry about affording whole life insurance premiums.
- You want to make sure your loved ones have a way to replace your income if you die within the next 10 to 30 years.
Choose whole life if:
- You’re a high-income earner (Clark says $400,000 or more annually) who wants to tap into your cash value as a tax-free loan.
- You’re a wealthy individual in your 50s or 60s, and you’re buying it for investment or tax purposes.
But again, Clark recommends term life policies in all most all circumstances.
“There’s no more efficient way that exists to replace income than with a level term insurance policy. They’re cheap, they’re simple and the amount of coverage you can buy for a very small monthly amount is fantastic,” Clark said. “They’re never going to be able to buy the level of replacement of income with a whole life policy that they can afford to buy with the term.”
Other Types of Life Insurance Policies
You may have heard of other types of life insurance. They’re essentially variations of whole life insurance. All three listed below include built-in cash value just like whole life insurance. Term life insurance is better for almost everyone.
Universal life insurance: A form of permanent life insurance that combines an investment element with lower premiums. The cash value earns interest based on the current market or minimum interest rate, whichever is greater.
Variable life insurance: A form of permanent life insurance that ties its cash value to sub-accounts that are similar to mutual funds. It’s a more volatile type of insurance because the rate of return on the investment portion of the policy is less predictable. The performance of its underlying securities determines the cash value.
Clark says it almost always makes more sense to choose term life insurance instead of whole life insurance. And as you saw in the table above, you can get better returns investing on your own rather than through your insurance policy.
If you make good financial choices, you may not need any type of life insurance policy by the time you hit retirement age and you are more financially independent.
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