Term Life Insurance vs. Whole Life Insurance – In Plain English

by Neal Frankle, CFP ®

Term life insurance vs. whole life insurance. Which is a better choice for you? Term life insurance policies serve a purpose. So do whole life insurance policies.

The purpose of term life insurance is to protect your family for a specific time period. If you buy the right term life insurance, it does the job beautifully well.

On the other hand, whole life insurance has two purposes. The first is to protect your family. (And if you face estate taxes, whole life insurance does protect you against that problem while term life doesn’t.) The second purpose of whole life insurance is to make insurance companies and agents lots of money.

That’s why term life insurance is bought while whole life insurance is sold.

Let me explain.

When you buy insurance (whole or term), the insurance company knows what your odds are of surviving during the period of the insurance. For example, let’s assume you are in excellent health, you are 35 years old and you want $100,000 worth of insurance. The insurance company sells you (and 5,000 other 35-year-old people) $100,000 worth of coverage. Let’s assume the insurance company knows that out of 5,000 35-year-olds, 20 are going to die this year. That’s what actuaries figure out. That means that it’s probably going to cost the company $2,000,000 in clams this year. Make sense?

Now, if the company is going to pay out $2,000,000 this year, they have to collect at least that much in premiums. That means the company must collect $400 from each of the 5,000 people who buy insurance just to cover their costs. Now, this is called mortality cost, and those go up each year. Why? Because as you get older, your mortality risk increases (the chances of you dying go up.) So the mortality cost might be $400 this year, but since a 36-year-old has a slightly higher risk of dying than a 35-year-old, the insurance company is going to pay out more money for every 5,000 people they insure each subsequent year. If you are very advanced in age, the premiums get really expensive. That’s why some folks consider guaranteed issue life insurance, but term life insurance for older people is usually a better bet.) You can either buy annual term insurance and pay higher premiums every year or buy 10, 20 or 30-year term. When you buy term insurance for many years, you pay a higher premium the first year than you would if you bought annually renewable term, but the premium is level for the period. So if you buy 10-year term, the premium for the insurance is going to stay the same every year for 10 years.

That’s because the company figures out what their risks and costs are each year and simply averages the cost. When you buy term, you pay that $400 plus extra to cover sales commission, the other costs the company incurs and the profit the company wants to make. Let’s say the total premium for $100,000 is $800 a year. When you buy a whole life policy, the insurance company has the same exact mortality and administrative costs, so they charge you the same costs. But it doesn’t stop there. The insurance company actually needs to collect more. A lot more. Why? Because with whole life, the deal is, you not only pay the cost of insurance, you pay extra.

The insurance company takes that extra money and invests it. In theory, the earnings from those investments should earn enough to pay the premiums for you. So, in other words, after a certain number of years pass, the insurance is paying for itself. Isn’t that wonderful? The only problem is that the insurance companies charge very high commissions for the investment elements when you buy whole life insurance, and it rarely works as they project. They also charge very high expenses. The bottom line is, you could invest that extra money yourself and grow it much quicker than if you bought whole life and let the insurance company do it for you.

That’s why term life insurance is much cheaper than whole life.

So why would you buy whole life?

You wouldn’t unless you had no choice. If your family is at financial risk that goes beyond your life (meaning you face estate tax liabilities), you will need whole life insurance to transfer estate tax risk. That is the only reason to buy whole life (or universal life for that matter). Term doesn’t work to solve the estate tax problem because you might die after the term expires. Whole life insurance never expires, and you won’t have to make premium payments if the company is able to invest the money well.

So you should buy term life insurance if you are financially responsible for others for a specific period of time. If your family will need money to also pay for estate tax, you might buy whole life.

The bottom line is, whole life insurance is not an investment. The returns are terrible because the costs are very high.

photo by Tarotastic Flikr

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