Term vs. Whole Life Insurance- Which is best for my family?
There are so many options out there when it come to getting life insurance for your family, that it can make your head spin. Most Investment guys will scream “Buy Term and Invest the Difference”. Insurance companies will tell you that you and your family deserve “permanent protection”. If you do a search on the internet, you will see heated discussions between the two parties, each accusing the other of just being after your money. If you already own a policy, you may find yourself wondering, due to some new information that you have received, if it really is the best thing for you. Properly protecting your family shouldn’t be this hard of a decision.
In my opinion, Term life insurance is the most beneficial for a family 95% of the time. This is why most third party experts, such as Dave Ramsey and Suze Orman, tend to back the BTID (Buy Term and Invest the Difference) philosophy. Unfortunately, if you were sold life insurance by a friend or relative, or if you sought out life insurance from an agent, chances are you have a cash value policy. The insurance companies tend to push these products, sometimes even when it is not in the clients best interest to do so. Of the cash value life policies, Whole Life is probably the best (stay far away from Universal or Variable life products, they are absolutely horrible, and if you have one of these policies, get out now, they are set to self-destruct, but that’s a sermon for another soapbox). Each individual has different needs, and each case is different, but you guys have no reason to take my word for it. Therefore, I am going to empower you to figure it yourself, by showing you how I found mine, and what I do for clients. All it takes is a calculator, a few quotes, and a little know.
STEP 1: How much insurance do you need, and for how long (if you go with term)? Each person is different, and there are a lot of factors to figure in which you may need the help of an expert (such as debt, length of mortgage, how old your children are, how much you make, etc.) A good rule of thumb would be 10-20 times your annual income, and getting you as close to retirement as possible. In my case, I was 32 with little savings when I got life insurance, and felt like I needed it for 30 years to give me a chance to build income. I Needed $500K on me, and $400K on my wife.
STEP 2: What is the maximum that I can budget to spend? If you shop for whole life, it is expensive. Unless you are wealthy, you may not be able to afford 10-20 times your annual salary, so an important factor in choosing your policy will be discovering how close you can get to your needed amount and if that is acceptable to you. I knew I couldn’t pay more than $200 a month for life insurance.
STEP 3: Get several quotes to compare. I would recommend getting at least 3 quotes on each type, and only from companies that carry an A+ rating with AM’s Best. You can check their ratings here: http://www.ambest.com/ .
Term life is very straight forward, but you do need to ask what options are available at the end of the term. This is just in case things don’t work out the way you plan. Most terms can be converted to whole-life, which is an OK option, but the best option is one that converts to a Decreasing Term, (or less insurance for the same amount of money). Chances are that if you still need insurance, you may not need as much, and term at, near, or after retirement age is expensive. You also need to make sure you are getting a fixed-level term (meaning your payments will not go up for the duration of the term), and that it can be renewed no matter what health you are in.
With Whole Life, you need to ask what the interest rate is on the cash value account. You also need to know how much of your money will be going into the savings account every month, and how soon it will start. Most of your monthly premium will be going towards the cost of insurance, and for the first couple of years the money that should be going into the savings is actually going out in fees and commissions.
When I was looking for mine, I took the most appealing (not the cheapest) of each category and compared them:
-I could get $500K on myself and $400K on my wife (with $10K on each of the kids) in a 30-year fixed level term for 30 years for $85/mth. OR
-I could get $150K on myself and $100K on my wife in Whole-Life for @ $200 a month. This policy had a guaranteed interest rate of 4%. Every month, approximately $110 paid for my insurance, and $90 went into the savings component. For the first three years, however, the $90 went out in fees and commissions.
Now for me, this was all the information I needed in making an informed decision. The most important factor in getting life insurance is getting the proper amount of coverage, everything else is secondary to that. It does my family little good for me to pay through the nose for life insurance that is not going to last my family very long if something happens to me. If I can not afford decent coverage with whole life, then I am better off with term. If you are under 55, and have a family depending upon your income, and can not afford 10 to 20 times your income with Whole Life, then you don’t really need to read any further, Term Life Insurance is your best option. But, just for the sake of expounding upon the determination process, I will show you how to complete the comparison.
STEP 4: Evaluate: in which case will my family benefit the most if something happens to me before the term is up? This is very simple, look at your face value and your cost per month. The answer here is almost always term. You get more bang for your buck. Even if the cash value is also available (and in most cases it is not), it is still not enough to cover the spread between the face values. In my case, it was a no-brainer: $500K @ $85/month vs. $150K @ $200/month. As I mentioned before, if I died tomorrow, $150K would not do much for my family, it would leave me woefully underinsured. $500K would pay off our mortgage and debt completely ,and supply my wife with @ $20K of annual income for the next 20 yrs. Term won that round.
STEP 5: Evaluate: In which case will my family benefit the most if something happens to me after the term expires? This is not only the most likely scenario, but this is also where is starts to get confusing for most people. In this case, you have to rely on projections and predictions. Here’s how to weigh the advantages and disadvantages of both: First of all, you have to know how to figure compound interest. The formula is Principal x (1 + interest rate) to the power of the number of years invested. If this is to complex for you, or you just don’t want to spend all day doing this, you can use this financial calculator.
Whole-Life: There is no way of knowing exactly when you are going to die, so the best thing to do is try to shoot for age 65 (the average retirement age of a person, when most people will cash out their savings). Remember that the first few years of the savings component are not being paid in, so you have to deduct them from the number of years saved. I’ll use my example again: $90 of my premium would have went into my savings component, and would have earned a guaranteed 4% interest. Since the first 3 years would have went out in fees and commissions, I would have app 30 years to invest. At the age of 65, I would have $62,464.45.
Buying Term and Investing the Difference: If you only buy term insurance, and do not put the remainder in my savings, the answer here would also be obvious. You would be better off with the Whole-life. Term life has no savings component, therefore your savings and face amount @ age 65 would be $0. However, remember that I advised you to see what you could budget for (in step 2). You can take the cost difference and invest it into your retirement, and get some pretty powerful results. This is what people are referring to when the say “Buy Term and Invest the Difference”. Shoot for the same age of 65 and run your results @ 6%, 8%, and 10% and see what you get. I’ll use my own example. The cost difference between my proposed whole life policy and my term policy was $115 a month.
$115 a month for 33 years @6%= $142,763.26
STEP 5: Weigh in other factors: Now, it was pretty obvious to me which savings method is the best for me. Neither one of these options is going to get me to retirement in and of themselves, but the key is that even if market performance is terrible, and I only receive a 6% rate, I will already have accrued enough money just in the savings from selecting term to have at least $142,763.26 that I can put aside in a separate account to take care of estate taxes, burial cost, and leave a small legacy for my family when something happens to me. At that point, I will no longer need life insurance. In addition to this, I would no longer have to pay life insurance premiums every month. With the Whole Life option, I would only have $62,464.45 in savings, and would have to continue paying premiums until the policy matures, which is usually around age 85. You would need to do a similar comparison.
Now, bear in mind when comparing these options that the 4% from the whole life policy is guaranteed, whereas retirement funds are not. Chances are that you will probably get a better return with “buying term and investing the difference”, but there exists a small chance that you may not. The difference needs to be significant enough that it is worth some risk to you.
Also, another factor to consider is the maturation date of the cash value of the whole life, and how it effects the death benefit. Most whole life policies do not pay the cash value plus the face amount until the cash value matures. In other words, If I were to die prior to age 85, my family would only receive $150K, and the insurance company would get to keep whatever cash value I had accrued. If I died prior to age 63 with term insurance, my family would have access to both my death benefit and my savings. If I die after 63 with term insurance, my family gets my savings, which is much larger than it would be if I had been spending all that money on whole life insurance.
If you ever make the mistake of “borrowing” money from your whole-life cash value, it gets even worse. You are charged 8% interest until you put it back, and if you still owe money when you die, they deduct it from your death benefit. For instance, if my face value was $150K, and I had $50K in my cash value. I could “borrow” (this is my own money I’m borrowing by the way) up to $40K. Let’s suppose I borrow $20K at age 56, and die at age 62 without repaying it. I would now owe $32,270.04, and therefore my family would only receive @$120K. If I took the same $20K out of my IRA, I would pay a 10% fee and be subject to capital gains tax, but my $500K death benefit would remain untouched.
I know this is a lot of information, but I hope it is helpful in making your decision. As, I stated before, most people are going to be better off with term, but not always. In a lot of cases, families that have been in Cash Value policies for years can still benefit from switching to term policies, although I would advise consulting a licensed expert before doing so. In today's world unfortunately, a lot of insurance policies are sold with smoke and mirrors, but the numbers don’t lie. Rely on the numbers, and the best of luck to you.