If you are interested in buying life insurance, you will inevitably compare term life insurance vs. whole life insurance.
This is because all life insurance types are either term or permanent (whole) coverage. Both term life and whole life insurance have their pros and cons, and there are several important differences between them that might make one better for you and your family.
Term Life Insurance vs. Whole Life Insurance: Who Wins For You?
Fundamentally, term life insurance only provides a death benefit; it’s pure insurance alone.
Term life protects you for a predetermined period of time, such as 5, 10, 20, or 30 years, but does not offer an investment option or build cash value. It is cheap for companies to offer, and that is reflected in its affordable rates. Statistically, less than 5% of term life insurance policies ever result in a payout, which may seem wasteful and discouraging until you realize you have to die for your family to earn a death benefit payout.
On the other hand, whole life insurance is permanent and builds cash value over your lifetime because it has an added investment component along with its pure insurance benefit. The cash value can be used as a forced savings account for retirement, a down payment on a future home, or a gift to your heirs.
Families can even use the whole life cash value as collateral for a low-interest loan that does not have to be paid back – the company simply deducts the balance owed from any future payout.
Term life insurance is cheap and whole life is 5 to 10 times more expensive. So, is whole life insurance a good investment or is pure term coverage the better policy option for you?
More On Term Life Insurance
Your term life insurance premiums guarantee one very specific thing: a set death benefit payout in the event of your death only while your policy is active.
This means that term life coverage functions as a “parachute.” If you calculate your life insurance needs correctly, a 20 or 30 year term life insurance policy should cover your family’s living expenses and liabilities during the most financially vulnerable time for you.
For most American families, this is when children are still young, the mortgage hasn’t been paid off yet, and a significant retirement nest egg has not been accumulated. During these years, an untimely death can be financially disastrous.
Both term and whole life policies are contracts.
In the case of term, the insurer lives up to their end of the contract by paying the promised benefit to your beneficiaries when you die. Yes, this means that the contract can expire without the company actually paying at all, even though for you to live up to your half of the contract, you must make each payment, and on time. Term insurance has monetary value for you and your family only if you die, but obviously, the peace of mind and financial security of protecting your family is the purpose to begin with.
Term Life Insurance Definition
Here is what you need to remember about the basics of term life insurance:
- Premiums: fixed for the term period, in most cases
- Death Benefit: fixed, but can be decreasing or increasing if you choose
- Time Period: temporary, most policies are for 20 to 30 years
- Cash Value or Investment: none
Convertible Term Life Insurance
Among term life policies is a kind of hybrid policy called convertible term insurance. “Convertibility” indicates that you have the option to exchange, or convert, your term coverage for permanent life insurance in the future. The new policy will be of equal value and the conversion will happen without a medical exam or underwriting.
As you might expect, this flexibility will cost you more than traditional term life and is no longer available once you turn 65 years old. The convertibility period is usually between 10 and 20 years after the policy is issued, so you have a deadline to decide.
Term Life Insurance Pros and Cons
When considering term or whole life insurance, it is crucial to understand the pros and cons of term life insurance.
- Cheap – term life insurance is cheap and affordable so families can purchase more coverage on a budget. Whole life policies cost 5 to 10 times more.
- Easy To Understand – term protection offers straightforward terms and conditions. You buy insurance and if you die while the coverage is active, your family is paid out the death benefit. Additionally, once your term policy is in place, your health is not an issue. Changes in your health during the tenure of your term do not affect your rates because premiums are fixed. There are no interest rates or returns to manage because there is no investment option.
- Minimal Commitment – if you ever stop wanting or needing term life insurance, just stop paying the premiums and your contract expires. Otherwise, with permanent or whole life, you may incur penalties, fees, and taxes.
- Flexibility – when it comes to the type, amount and length of coverage, consumers have a broad range of choices. Policyholders can even buy cheap term life insurance now and convert it into permanent protection in the future.
- Investment Options – although term contracts do not have a cash value feature, the cheaper premiums allow you to take your savings and invest in other assets, such as equities, mutual funds, bonds, real estate, commodities, etc.
- Outliving Your Contract – some consumers believe that, if they outlive their policy, they will have thrown away their premiums. We wish you a healthy, successful and happy life, one in which your family will never need the death benefit.
- No Cash Value or Equity – if you need help saving for retirement, term life does not offer an investment opportunity. You are simply paying for insurance coverage. When compared with whole life insurance, term life does not have an inherent value unless the benefit is paid.
- High Renewal Rates – because the cost of term life insurance is largely based on your age, health and risk profile, if your policy expires and you feel the need to renew for future coverage, your rates will be significantly higher. This is why insurance experts recommend consumers buy 20 or 30 year term life insurance when they are young and healthy.
- Premiums May Change – depending on the type of term policy you purchase, rates may vary. Most policies guarantee level rates for the complete term period, while others offer fixed rates for the policy’s first year and increase afterwards. This is something you should research carefully and ask your company about.
What Is Whole Life Insurance?
Whole life insurance, a type of permanent life insurance, provides death benefits like term life insurance does. The death benefit is fixed, however, permanent policies also offer a cash value or investment component. This is because a portion of your premium is diverted to the cash value, acting like a “forced” savings account.
The insurance company then guarantees a fixed rate of return on your cash value, averaging around 4% depending on your provider. Over time, your cash value increases, making whole life insurance a low-risk and stable investment.
As you might expect, the premiums for whole life coverage are higher, costing up to 10 times more than term life. Although term is your cheapest option, whole life insurance rates do not change over time because policies do not expire. Whole is active until your death, unless you withdraw the full cash value or stop paying the premiums.
In the case of whole life insurance, the company’s contractual obligations are a bit different. As the policyholder, you complete your half of the contract by making timely, lifelong annual payments. Your insurer completes their half of the contract by paying your beneficiaries the agreed sum when you die, no matter when, assuming you don’t cash out and/or void your policy.
Whole Life Insurance Definition
When considering whole life insurance, here is what you need to know:
- Premiums: permanently fixed, but a policy can be paid off in a lump sum or modified time period
- Death Benefit: fixed, minus the net balance of outstanding loans using the cash value as collateral
- Term Period: permanent; as long as your premiums are paid, the contract cannot be canceled or voided
- Cash Value or Investment: yes; the company pays a fixed interest rate, usually around 4%
As with term life policies, medical examinations are an issue at the time you purchase your policy, and your answers on any questionnaire will be confirmed by your physical exam and blood test. However, in contrast to the term life policy, as long as you maintain your whole life policy, you will not have to submit to a medical examination again. In other words, because there is no need for renewal, you do not need to worry about your health or premiums in the future.
Whole Life Insurance Pros and Cons
Although term may be the most commonly purchased policy, every family’s financial situation is unique. Compare the pros and cons of whole life insurance to determine whether it fits your future goals.
- Forced Savings Account – many Americans lack the discipline or budgeting skills to save. Whole life insurance commits a family to planning for long-term financial security.
- Tax-Deferred Investment – your insurance company pays you interest on the investment portion of your policy, and the gains accumulate tax-deferred. Unlike stock portfolios, mutual funds, real estate, or other investments, you do not pay capital gains taxes. This is similar to a Roth IRA, yet there are no restrictions or penalties on when you can withdraw your money.
- Tax-Free Withdrawals – whole life policies are unique because they permit you to borrow against the policy’s cash value, tax-free, during your lifetime. This ability to borrow against the policy is one of the features that you pay more for. Just remember, if the loan is not paid back into the policy, the net balance owed will be subtracted from your death benefit payout.
- Consistency – your death benefit and premiums are locked-in and fixed. Many whole life policies even set the interest rate on the cash value permanently.
- Long-Term Commitment, No Flexibility – the downside to so much predictability is that whole life policies are more restrictive and unyielding than term life policies. The value of the policy never changes, but neither do the payments – no matter what. Whole life insurance is permanent coverage. If your financial situation changes and you cannot afford the premiums, all you can do with your whole life policy is decrease its value by borrowing against its cash value or stop paying the premiums, suffer a surrender penalty, and lose all your protection.
- Fees, Expenses, and Costs – whole premiums aren’t cheap to begin with, and not all your money goes directly to paying for insurance and growing your cash value. Fees and charges include mortality, administrative expenses, surrender penalties, state premium taxes, withdrawal fees, etc. These expenses lower your overall contribution to the policy’s cash value.
Buying Life Insurance – The Medical Exam
Most term and whole policies require medical examinations for the underwriting process. The exceptions are no exam life insurance and guaranteed life insurance.
Insurance companies offer free life insurance quotes based on your personal information and medical history. However, final premiums depend on your current, verified health so be honest on your application/questionnaire because any material misrepresentations will come to light after a physical health exam and blood test.
Factors That Affect Life Insurance Rates
- Your Age, Gender, and Occupation
- Current Health and Weight
- Your Medical History
- Family Medical History
- Smoking or Drinking Habits
- Dangerous Hobbies or Lifestyle Choices
For example, imagine that you are 35 years old and have two young children. You choose a 20 year term life policy to ensure that your children will be adults by the time the term expires.
You calculate that $500,000 is enough to cover any possible needs for your children and spouse, and the insurance company quotes you an annual rate of $250.
However, after you undergo your physical examination, your actual yearly premium increases to $300, even though you are currently healthy. The increase is a result of your family’s medical history, indicating you are at high risk for diabetes and heart disease. Assuming this is about the same price other carriers will offer, you can either agree to the premium increase or not buy coverage at all.
Once your term life policy is in place, your health is not an issue. Changes in your health during the tenure of your term do not affect your rates. Of course, health changes can and usually will impact renewal rates; in fact, health changes for the worse can even make renewal of term life policies impossible in some cases.
The Final Word – Our Recommendation
Whole life policies are significantly more costly because they guarantee a pay out and offer an “investment” component that accrues value at a tax-deferred rate. However, most experts agree that investing through your whole life policy just isn’t as wise as using stocks, bonds, index or mutual funds, IRAs, 401Ks, real estate, retirement accounts, etc.
In fact, whole life insurance is most valuable as an investment for those lucky few without consumer debt, with incomes of at least $250,000 to $300,000 annually, and with sufficient savings for all anticipated major purchases, such as tuition and real estate. Generally speaking, whole life insurance is used by high net worth individuals seeking tax-advantaged investments.
If this isn’t you, keep your investments and savings separate from your insurance coverage and buy a term life policy.
By purchasing cheap term life insurance, you can take the difference in premiums and invest in other assets, such as an index fund, stock portfolio, and/or investment property. The stock market has returned, on average, approximately 9% over the last 100 years, a return far greater than the guaranteed 4% you will earn, after fees, on your whole life cash value.
In the long run, your retirement nest egg will generate higher returns and provide more income.
Our recommendation – buy affordable term life insurance and invest your money outside of an insurance policy, unless you are absolutely certain whole life is the right policy for you and your family’s needs.