Life insurance provides important financial benefits, but navigating the landscape of its terms and implications can be tricky. You're sure to encounter different and confusing policies and phrases, such as whole life, term life, cash value, and variable life.
How Life Insurance Works
Life insurance policies have a death benefit, which your named beneficiaries can claim when you die. You can choose any type of beneficiary you like: your children or spouse, a business partner, or a beloved charity. Typically, individuals buy life insurance to cover themselves, but you may also consider purchasing a policy to cover your spouse or parent, or to establish a savings vehicle for your child.
Life insurance falls into two categories: Term life policies provide coverage for a specified period, while permanent life insurance offers extended protection. Both types of coverage have advantages and disadvantages, but each is tailored to meet the needs of a diverse range of policyholders.
So which type of life insurance policy is best for you? Whether you're in your 20s or 60s, deciding on the right policy type should be a priority. Weighing the details of various policies can help you decide.
Term vs. Whole Life Insurance: The 2 Primary Types
|Term Life Insurance||Whole Life Insurance|
Covers you for a set period, so you have the option of paying for coverage only when you think you might need it
Premiums may be affordable if you're relatively young and healthy
Policies don't accumulate any cash value
Renewal may be more difficult, and your rate may increase, if your health deteriorates during the term
Provides indefinite protection until the date of your death
The rate is fixed over the life of the policy, so you can "lock in" lower premiums if you purchase a policy while you're young
Accumulates value over the years so you can borrow against it or take withdrawals
Premiums are often more expensive than term life policies
Term Life Insurance
Term life insurance protects you for a specific period, usually up to 30 years. Typically, the death benefit remains level throughout the life of the policy, even if your health declines during the term. If you purchase a 10-year, $100,000 policy, it will pay a $100,000 death benefit to the beneficiary if you die during the 10-year coverage period.
If you choose a decreasing term policy, the death benefit declines during the life of the policy. This type of policy can provide adequate protection for a mortgage, which decreases with each monthly payment.
Term life policies usually provide the most affordable coverage for young people because rates are based on age and health.
Term life policies only pay a death benefit and don’t build a cash value over time. Typically, term life policies don’t return any of your money when the term ends. Policies that include a “return of premium” feature will pay back some or all the premiums you paid, but they come with higher rates. You may be able to renew a term life policy at the end of the term, and some policies can be converted to permanent life coverage, which extends coverage until you die, regardless of your age. However, most term life policies only offer coverage up to a specified age, so before you buy a term life policy, ask if you’ll lose the ability to renew when you reach a certain age.
Cost and term flexibility are among the advantages of term life insurance. You can use a term life policy to ensure your kids get a college education, your spouse pays off the mortgage, and your family replaces your income if you pass away. Term life policies feature flexible coverage levels, so you can choose the death benefit that fits your needs. For example, if you want to cover your $100,000 annual salary for five years, you can purchase a $500,000 policy.
Since term life policies don’t build a cash value, when the term ends, you may feel like you’ve thrown away your money. And if you plan to renew at the end of the term, you may end up paying a higher rate if you develop health problems during that time. Since a term life policy will only cover you up to a specified age, it won’t provide protection for your survivors if you live well into your golden years.
Whole Life Insurance
Whole life insurance is the granddaddy of permanent life insurance policies. It’s called “whole” life because it covers you until death, regardless of your age at that time. This type of life insurance features a fixed death benefit, and over time, builds a tax-deferred cash value.
By law, whole life policies must contain nonforfeiture values, which are paid in cash or another type of insurance if you fail to make payments or decide to drop the coverage.
Whole life policies come in many forms:
- Nonparticipating whole life insurance: Features a fixed premium and death benefit, along with a set cash surrender value determined by the provider
- Participating whole life insurance: Enables you to receive dividends on the carrier’s investment, which you can use to pay future premiums or reduce your rate
- Indeterminate premium whole life insurance: Features adjustable premiums, while limited payment policies allow you to make premium payments over a shorter period while retaining protection throughout your life
Whole life policies can provide an inheritance for your loved ones and a savings plan for you. Once the policy builds a cash value, you can borrow or withdraw funds for expenses such as unexpected medical costs, a down payment on a house, or a wedding gift for one of your children.
Whole life policies aren’t as flexible as term life options because you can’t change the face value or adjust the rate. They also cost more than term life policies because they cover you for your entire life and their savings feature increases the insurer’s administrative costs. A traditional whole life policy may not produce the highest earnings possible, but more modern types of permanent life insurance, which we’ll address in the next section, offer more flexibility and possibly higher gains.
Other Types of Life Insurance
Term life and traditional whole life insurance policies are the most common on the market. Other types of permanent life policies offer more flexibility, but sometimes increase financial risk. Meanwhile, group life insurance policies can offer affordable term life coverage, but with restrictions that may not provide enough protection. To find the policy that best fits your needs, dive into the details.
Universal Life Insurance
A universal life policy protects you as long as you pay the premium. Like whole life, universal life insurance builds a cash value over time. However, universal life policies apply earnings based on a money market rate of interest. A universal life policy gives you the option to change your death benefit and allows you to adjust your premium payment once the policy accumulates a cash value. This permanent life coverage allows you to take out a loan against the cash value if you have enough earnings to cover policy costs.
Variable Life Insurance
This type of permanent life policy earns a cash value and provides more flexibility than universal life because it allows you to invest a portion of the premiums in bonds, money market mutual funds, or stocks. If you invest wisely, your cash value may grow quicker than it would with other types of permanent life insurance. However, if your investments don’t perform well, the death benefit and cash value may decrease. Some variable life policies minimize risk by guaranteeing your death benefit won’t decrease below a specified level.
While universal life policies allow you to change the death benefit, variable life insurance policies do not.
Variable Universal Life Insurance
Variable universal life insurance blends the features of universal and variable life insurance by allowing you to invest in bonds, money market mutual funds, or stocks, and enabling you to change your death benefit and adjust premiums. Some variable universal life policies also allow you to make tax-free transfers amongst your investments.
Indexed Universal Life Insurance
An indexed universal life insurance policy earns a cash value based on the performance of a market index, like the S&P 500 or a bond. Indexed universal life policies don’t feature an interest rate guarantee and may be subject to caps and floors. If you accrue a substantial amount of cash value, you may forgo premium payments for a certain period, but if the index performs poorly, you may end up paying a higher premium.
Group Life Insurance
Typically offered through employers, associations, or professional organizations, group life insurance covers a group of people. A group policy is owned by the entity that purchases it—for instance, an employer—not the individuals it covers. Group policies offer term life coverage, usually with many restrictions. The policyholder can dictate when your coverage will begin and when you can make changes to your coverage level. Although a group life policy may have a portability option, if you choose not to continue coverage, your protection will end when your association with the policyholder ends. For instance, if you quit your job and decide not to continue coverage, your policy won’t protect you after your last day of work.
Group life insurance has advantages and disadvantages. The policy owner may offer coverage for free as part of a benefits package, or for less than you’d pay for a personal term life policy, but there may be a limit on the amount of the death benefit. Some employer group life insurance policies base coverage on a multiple of your salary, which may not provide enough protection for people who earn lower wages. And if the policy is carried directly or indirectly by an employer and your coverage exceeds $50,000, the IRS will consider it a taxable fringe benefit.
Most types of life insurance require you to undergo a medical exam, which is essentially a physical. Insurers use the results of this physical exam to determine your premiums, and being healthier can make a big difference in your cost.
No-Exam Life Insurance
If you don’t want to take a medical exam to qualify for life insurance, your options are more limited. You may be able to avoid taking a medical exam by converting a group life insurance policy to a whole life policy when you leave a job, for example. Another way to avoid a medical exam is to buy burial insurance, which is a type of whole life insurance that only covers funeral and burial costs.
However, you can also buy a no-medical-exam policy, such as simplified issue or guaranteed issue life insurance. These types of term life policies tend to be more expensive than the traditional options described above, but they may allow you to get the coverage you desire without taking a medical exam.
Choosing Between Different Types of Life Insurance
Choosing the right type of life insurance requires you to consider your circumstances and what you want a policy to achieve. Term life policies provide great protection when you have a mortgage or young children and need coverage for up to 30 years. Folks who are young and single with no dependents may only need the limited coverage offered by an employer group insurance policy, which could provide enough money to pay funeral and burial expenses. Permanent life policies are a great way to provide an inheritance for your family, and if you purchase coverage while you’re young and healthy, you may enjoy a lower premium.
Consider Your Goals
Before purchasing a life insurance policy, decide what you want the death benefit to accomplish. Determine your coverage level based on realistic factors, such as the amount of money your surviving spouse will need to replace your income for a few years or pay off a mortgage. Avoid high-risk policies such as variable life insurance if you have little or no financial experience, but consider the potential gains if you’re a seasoned market watcher. Since permanent life insurance policies earn a cash value over time, also consider long-term goals that the savings might help achieve while you’re alive, like buying a home or taking a dream vacation.