When making financial decisions, we like to stress that circumstances matter. Your wants and needs make a decision good for you, even though it might not be the best choice for me. This is less true, though, in deciding whether to purchase term or whole life insurance.
Term life insurance is almost always the better option. First, let’s get an understanding of each type of insurance, and then we’ll look at why term life insurance is usually a smarter choice.
What is whole life insurance?
As the name implies, whole life insurance is a life insurance policy that covers you for your entire life, assuming you are paying the premiums. The idea that the policy has no end date is appealing to some customers.
Whole life insurance differs from term life insurance because it provides both a death benefit and a savings account. Insurance agents like to refer to these “forced savings” as a form of retirement savings. You can withdraw or borrow against this cash value savings account portion of the policy.
In addition, insurers sell this policy by emphasizing that the cash value grows over time. Eventually, you could cash out the savings portion of your policy. Since a portion of your premiums is going towards this savings account, whole life premiums typically cost 5 to 10 times more than term life premiums.
What is term life insurance?
Term life insurance is life insurance that covers you during the life, or term, of the policy. Terms range in length from 1 to 20 years.
There is no forced savings associated with term life insurance. For this reason, term life policies tend to be less confusing and more convenient for policy holders than whole life policies.
Term life premiums are also significantly cheaper than whole life premiums, particularly if you are under age 50. The premiums for some policies rise a little bit every year, but level term life insurance policies have steady premiums for the entire term. Either way, though, your premiums are likely to be much less expensive than premiums on a whole life policy with a similar death benefit.
Why is term life insurance better?
Whole life insurance is usually significantly more expensive than term life insurance. You would assume this means your whole life policy provides a noticeable extra benefit. One purported benefit is that you can receive life insurance beyond age 65. Term life policies typically won’t cover you beyond age 65.
On the surface this might seem attractive, but it doesn’t actually matter. The idea of life insurance is that it provides for the people who depend on you and won’t be able to care for themselves in the case of your death. For example, life insurance is designed to help provide for young children if their parents pass away. By the time your term policy expires—likely around age 65—your kids will be old enough to care for themselves. In addition, most liabilities, like loans, will be repaid by that age.
So how else do insurers justify the much higher premiums for whole life policies? They say a portion of your premiums goes towards an investment—it might be bonds, money-market instruments, stocks, etc.
You can borrow against this savings account, or you can use it as a retirement account. This might seem like a good idea, except these policies typically come with large commissions and high fees. In addition, there are much better ways to invest for retirement.
So with whole life insurance you’re essentially paying a higher premium in order to put money into a bad retirement investment. Typically, you’ll come out on top by investing that extra money in a mutual fund or another solid investment.
Is whole life insurance ever a good idea?
To be clear, buying whole life insurance is not always a bad idea, as the high premiums are suited for wealthier people. Whole life policy holders might benefit from using the whole life policy in their estate planning or by setting up an insurance trust to pay estate taxes. Borrowing or withdrawing from the cash value could be a useful investment strategy, as well. However, in the vast majority of cases, choosing term life instead of whole life insurance is the smart decision.
Published or updated March 20, 2013.