Search around the web for the best type of life insurance, and you’ll find lots of financial advisers who say, without hesitation, that term life insurance is best. While I generally agree and have term life insurance myself, the right answer for each individual is not always that easy.
The truth is that with life insurance, as with many financial products, “best” is a relative term. The question isn’t, “Which is best overall and for all time?” The question is, “which type of policy is best for me?”
The best life insurance is the one that suits your needs based on your current and predicted future financial situation.
Here, we’ll talk about the major types of life insurance – term, return-of-premium term and permanent – and look at the pros and cons of each. Then, you can decide which type of life insurance is best for you.
Term Life Insurance: Most Recommended Option
The American Council of Life Insurers says that term life insurance policies accounted for 3.7 million new policies totaling $1.1 trillion in face value in 2011. That’s nearly three-quarters of the face value of all individual life insurance policies issued in 2011.
That’s not surprising, given that most financial professionals (at least the ones who don’t get hefty commissions from selling permanent life insurance) say term is best.
And, in many cases, term life insurance is the best option. With term life insurance, you pay a set monthly premium for a certain amount of life insurance coverage for a certain amount of time. You might get $500,000 of insurance for 20 years, or $2 million for 10 years, depending on your circumstances.
But the key to term life insurance is that it’s for a set term and that the payments don’t change. Here are some of the pros and cons of term life insurance:
- Inexpensive: Term life insurance policies are much less expensive than comparable permanent life insurance policies. The premium for return-of-premium life insurance is higher than regular term insurance, too.
- Fixed rate: Level term life insurance policies – where you’re paying for a set amount of coverage for the entire term – come with predictable, fixed payments.
- More coverage for less: Since term life insurance policies are cheaper than other options, they can make higher amounts of coverage more affordable. This is appealing, especially, to young families on a tight budget who need plenty of coverage without a high monthly cost.
- Customized coverage by age: If you’re a parent with young children or have lots of debt, you’ll probably need extra coverage for the next couple of decades. But after your 20-year term is up – once you’re debt-free and have an empty nest – you can drop most of your coverage, carrying just enough life insurance to cover end-of-life expenses and other necessities, or eliminate coverage completely.
- Simple to cash in: As long as you stay current on your life insurance premiums, there’s no complication when it comes to cashing in your death benefit. If you die, you get the coverage you’ve paid for, as simple as that.
- Can be hard to get: Term life insurance is cheap because insurers are picky about whom they’ll take on. It can be difficult – or very expensive – to get term life coverage if you’re in poor health.
- May become uninsurable: You could become uninsurable during a contract period, which means you won’t be able to extend your coverage past that point. This is why many financial advisers advocate for longer terms – 30 or 40 years. These terms could last well into retirement, when you’re less likely to need coverage.
- Health-based payments: As with all types of insurance, your premiums for term life will be based on your risk factors. The less likely the insurance company will pay the death benefit, the cheaper your coverage will be. So if you’re obese, smoke or have other chronic health issues, your premiums will be higher.
- Can require a health exam: Related to the last point, many term life insurance companies will require a health exam before offering you coverage. An exam could be as simple as a weight check and health questionnaire. But if you’re applying for millions in life insurance coverage, expect to jump through more health-exam hoops before gaining coverage.
- You may get nothing: Term life insurance is more like car insurance or homeowner’s insurance than the other two major types. If you outlive your policy, you don’t get the death benefit or anything else back. It won’t help you save money or give back your premiums, it’s purely insurance.
Pros and Cons of Return-of-Premium Term Life Insurance
Return-of-premium term life insurance is somewhere between term life and permanent life. It’s like term life in that you pay for a set term, usually 20 to 30 years, but sometimes more. Over the term, you’ll pay a level premium every month. If at the end of the term you’ve kept up with your monthly payments, your premiums will be refunded to you.
The death benefit for a ROP term life insurance policy pays out like regular term life insurance. When you die, your beneficiaries get a tax-free death benefit that goes to them automatically. But unlike term life insurance, ROP life insurance builds cash value that you can borrow against if you need a loan during the insurance term.
So ROP term life is a lot like both other types of insurance, and it has its pros and cons:
- Payment either way: You’ll either get every penny of your premiums paid back, or you’ll get a death benefit. Either way, you or your family members get a potentially large check during or after the term period.
- Fairly affordable: It isn’t as cheap as regular term life insurance, but it’s more affordable by far than permanent life insurance. You can expect to pay about 50 percent more in premiums than you would for a similar term life insurance plan.
- Easy to get: It’s relatively easy to get, and it’s easy for your family to deal with if you should die.
- Coverage when you need it: You can change your life insurance as your needs change. When your kids are young, you can get more, but when you retire, you can apply for another term with less coverage.
- Won’t make money: With a permanent life insurance policy, part of your premium is invested, and some of that investment comes back to you. With return-of-premium term life insurance, the insurer keeps the interest it’s made while investing your premiums, and you get exactly what you put in. You’re basically giving your insurer a free loan, if you don’t need the death benefit.
- No payout if you cancel or miss payments: If you cancel your ROP term life insurance policy – or miss payments on it – you won’t get much in return. According to most policies, if you let go of your policy before the term is up, you’ll receive a small percentage of the premiums you’ve paid in.
- Could invest the extra: The argument here is similar to the one you’ve probably heard about permanent life insurance: If you take the money you’re putting into premiums and invest it on your own, you’ll probably come out ahead. Because you’re getting no return on your investment with ROP term life insurance, this is definitely true.
Pros and Cons of Permanent Life Insurance
Permanent or whole life insurance is by far the most complex option of the three. In fact, there are, according to the American Council of Life Insurers, four types of permanent life insurance: traditional whole life, universal life, variable life and variable-universal life.
We’re not going to get into all the differences here. Instead, we’ll talk about the basics of permanent life insurance, along with its pros and cons.
Basically, a permanent life insurance policy is both a savings/investing vehicle and life insurance. With a permanent life insurance policy, your coverage is guaranteed for life – as long as you keep up with your premiums. As you pay into the policy, you build up cash value, which you can later borrow against.
Plus, part of your premium is invested, so the cash value of your policy is more, over time, than what you pay in (unlike with a return-of-premium term life insurance policy). Permanent life insurance builds up cash value very slowly, but it can turn into a significant amount of tax-free savings.
Permanent life insurance hasn’t been a favorite of financial advisers because it can offer lower returns on investment than other investing options. But according to US News and World Report, permanent life insurance policies are on the rise, and they’ve paid out fairly well over the past five years.
In a volatile economic and investing climate, permanent life insurance is more attractive because it offers a safer investment vehicle. In fact, the Wall Street Journal says that for some individuals, adding permanent life insurance to a term life policy is a good idea.
Is permanent life insurance the right choice for you? Check out the pros and cons:
- Doesn’t expire: You never have to worry about a lapse in coverage. As long as you continue to pay the premiums, it’s always there with a death benefit waiting for your family. Even if you contract a serious illness, your insurer can’t drop your coverage. So if you’re worried about being unable to renew a term life policy down the road, permanent life insurance can offer peace of mind.
- Forced savings: Those who lack financial discipline may have trouble with basic savings, and permanent life insurance can be a good tool for them. Permanent life insurance gives you incentive to save – if you don’t pay your premiums, which are saved for you, your life insurance coverage will lapse.
- Good option for the wealthy: If you have a large estate that will be hit with serious estate taxes upon your death, permanent life insurance can be a good option. The death benefit is tax-free and can be used to pay estate taxes upon your death.
- Helpful for long-term financial support: Term life insurance is ideal for average families whose children will be self-supporting by the end of the term. After your children are on their own, you don’t need to worry about having hefty life insurance coverage to care for them in the event of your untimely death. But what if your child, spouse or another dependent can never be self-supporting for some reason? In this case, permanent life insurance is a way to ensure that – no matter what – your loved one is financially set after your death.
- Expensive: Permanent life insurance is hands down the most expensive option. It is cost-prohibitive for some individuals, who are better off with a term policy they can afford.
- Slow-growing: If the policy is too expensive, you may cancel in the first few years. But you won’t break even with your insurance policy’s cash value until the policy is 12 to 15 years old.
- Complicated: As noted above, there are several types of permanent life insurance. And policies can vary widely from one company to the next. It’s best to shop around with a good, independent insurance agent who will help you find your best permanent life insurance policy.
- Could earn more elsewhere: The biggest argument against permanent life insurance policies is that you could invest the money you’re spending on premiums in a higher-earning account elsewhere and be better off in the long run. And most of the time, this is true. This is partly because permanent life insurance policies come with high fees and administrative costs, so that seriously cuts into your returns, which average 4-5 percent at most.
The Bottom Line
Which life insurance policy is best for your particular needs? It depends, as you can see. The information above is meant to give you an overview of the pros and cons of various life insurance vehicles. But you may still be wondering which option is best for your situation. In that case, here are a few quick things to consider:
- Be sure you can afford it. The American Council of Life Insurers put the termination rate of individual life insurance policies at 6.1 percent in 2011. That’s a lot of money down the drain! If you can’t afford your premiums, you’re more likely to let your coverage lapse. So be sure you can fit premiums into your budget – even if you take a few financial hits in the future.
- Know how much coverage you need. Many financial advisers recommend getting at least 10 times your annual income in life insurance coverage. Stay-at-home parents with no personal income should look at the dollar value of the services they provide the family – cooking, cleaning, childcare, etc. – to estimate life insurance coverage needs.
- Look to the future. If you’re getting either type of term policy, figure out what your next couple of decades will look like. Will you have children at home or in college? Will you be in lots of debt or debt free? All of these will factor into how much insurance coverage you need.
- Get multiple quotes. As with any major financial decision, it’s not a great idea to buy life insurance from the first insurer you check out. Get several quotes based on your situation. You can start with our online life insurance quote page.
- Understand what you’re buying. Steer clear of life insurance agents and companies who won’t clearly explain what they’re selling. If you don’t understand all the details of a life insurance policy, walk away.
- Consider life insurance a need. Life insurance isn’t a luxury when you consider what could become of your family without it. If you fall on tough times financially, life insurance premiums should be on your list of most important bills to pay.
Do you have other questions or concerns about life insurance? Let us know how we can help in the comments!