Comparing Life Insurance Policies
Each type of insurance policy has benefits and drawbacks
Life insurance provides important financial benefits, but navigating the life insurance landscape can be tricky. You're sure to encounter different policies and phrases such as whole life, term life, cash value, and variable life, which can be confusing if you're not an insurance expert.
So how do you make sense of all the different types of policies without feeling overwhelmed? Here’s a quick breakdown of the most common types of insurance policies and the pros and cons of each.
Term Life Insurance
Term life is exactly what it sounds like. You purchase life insurance for a specific term or time period, which may be anywhere from five to 30 years. You pay premiums for the entire length of the term; once the term expires, so does the policy. If you pass away before the term ends, the policy pays a death benefit to your beneficiaries. Death benefits can be as low as $5,000 or as high as $5 million, depending on your needs.
Cost-wise, term life is generally the most affordable type of life insurance. Premiums are based on your health and the amount of coverage you choose. The younger and healthier you are, the cheaper coverage is likely to be.
Term life can be broken down into a few different categories:
- Level Term—Your premium and death benefit remain the same for the entire length of the term, whether that is 10, 20, or even 30 years.
- Annual Renewable Term—The death benefit remains unchanged throughout the term, but the contract renews annually, usually with an increase in premium each year. Initially, premiums may be less than in a level term policy, but over time it can become more expensive.
- Decreasing Term—Here, the death benefit decreases each year while the premium remains the same. The policy ends when the death benefit reaches zero.
Advantages of Term Life Insurance
Term life policies offer the flexibility to buy only the coverage you need. For example, if you’re only concerned about life insurance while your kids are young or you have a mortgage to pay, you can get coverage for 20 years instead of paying for a longer policy that you may not really need.
Disadvantages of Term Life
Term life policies don't accumulate cash value. And having a specific term can also be a drawback. If you purchase a 20-year term policy and after 20 years decide you’d like to extend your coverage, you may need to undergo proof of insurability and could be denied additional coverage or need to renew at a significantly higher premium.
Universal life insurance is a type of permanent insurance that covers you for your entire lifetime, with a cash-value component. Here, instead of just selecting a specific term and putting 100 percent of your premium toward the policy, part of your premium will actually go into a cash account in the policy. This cash account earns interest and accumulates tax-deferred.
Advantages of Universal Life
Universal life insurance offers more flexibility than term life. Because it has a cash component, you could actually temporarily stop making premium payments as long as the cash value can cover the cost of insurance. In addition, you may also be able to increase or decrease the death benefit over time. Also, you can usually take tax-free loans against the cash value in the policy.
Disadvantages of Universal Life
Because it's permanent coverage, universal life tends to be more expensive than term life. While some of that added cost will be going into the account in the form of building cash value, the rates you earn on that money may not be as high as what you'd get from investing in stocks or mutual funds. That's why many financial professionals recommend buying term and investing the difference. This allows you to still purchase a death benefit while having the flexibility to invest the difference anywhere you choose.
Variable Universal Life Insurance
Variable life insurance is very similar to universal life with one major difference. With this type of policy you aren’t earning a specific rate of interest in a cash-value fund, but instead, you can invest this portion in a variety of different investments like mutual funds. So, you get more control and potentially higher returns from your cash value.
Advantages of Variable Life
You’re still guaranteed the minimum death benefit as long as you keep up with the minimum premium. You also have the flexibility to invest the cash-value portion in a variety of investment vehicles. If you make wise investment decisions, you can take advantage of significant tax-deferred earnings on those investments.
Disadvantages of Variable Life
By investing part of your policy in possibly risky investments, you could put your policy in jeopardy if the market turns south. A significant drop in account value could force you to pay additional premiums just to keep your policy in force. In addition, the expenses associated with the investments in variable universal life may be significantly higher than you might pay elsewhere.
As the name implies, whole life is meant to cover you for your whole life. Like universal life, whole life has a cash-value component. In most cases with a whole life policy, the premium and death benefit are fixed. The younger you purchase coverage, the lower your premiums are likely to be. Whole life is often marketed to parents as an investment for young children, on the premise that they can lock in coverage while they're young, making it more affordable once they become adults.
Advantages of Whole Life
There are no surprises with whole life. You have a guaranteed premium, interest rate, and death benefit for the life of the policy. The cash value also grows tax-deferred and also typically allows for withdrawals and loans against the policy.
Disadvantages of Whole Life
Whole life is generally more expensive than both term and universal policies. This is largely due to the added guarantees that come with whole life. Also keep in mind that the policy is less flexible; changing your death benefit or premiums isn't an option. Like universal life, the interest earned on the cash-value account may be less than you could get elsewhere.
A number of life insurance options are available, and what's right for you may not reflect what's right for someone else. Taking time to learn what each type of policy offers can ensure that you choose a policy that’s best suited to your long-term needs and financial situation.