When you start shopping for life insurance, you will come across two different types, whole life and term. Here is an objective review of whole life insurance as an investment option. Today, I want to clearly explain whole life insurance and give better details about when you need life insurance.
When you need life insurance
If you’re like most, you may not need life insurance until you have kids. Since the primary purpose of life insurance is to replace your income for the people who depend on it if you die. But in some cases, you might want to get life insurance for your spouse before you have kids. Few cases of young and single people need life insurance.
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What is whole life insurance?
There are primarily two types of life insurance: term life insurance and permanent life insurance (either whole or universal).
Term life insurance
With term life insurance, you pay premiums for a specified term (usually 20 or 30 years), and if you die within that term, the insurer pays your survivors a benefit. But term insurance is like car insurance: if you stop paying premiums, of course, you lose the insurance.
Permanent life insurance
With permanent life insurance, your insurance remains as long as you’re paying premiums. In addition, some of the money you pay in premiums accumulates as a cash value. You can use this cash value to save for retirement or even take loans against it throughout your life.
The difference between whole life insurance and universal life insurance is that premiums are fixed for life. In contrast, universal life insurance allows you to adjust the premiums and death benefits as you go.
After several years, with whole life insurance, some of the money you’ve paid is yours to keep even if you stop paying premiums. This is called the policy’s cash value.
For insurers, whole life insurance can be an easy sell. Nobody likes “throwing money away” on life insurance, so the prospect of combining life insurance policies with a way to save tax-deferred money for retirement is attractive.
The pros and cons of whole life insurance
The biggest drawback to whole life insurance is that the premiums are way more expensive than term life insurance. Assuming equivalent investment returns, because of how the policies are written, it takes a lot longer for a whole life policy to accumulate significant cash value (often 12-15 years) than if you invested on your own.
So for a young investor with limited free cash to buy the insurance and invest for the future, this is why I only recommend term life insurance. It’s better to pay the cheaper premium and have savings left over to invest, use as an emergency fund, or spend as needed.
Whole life is a mediocre investment
With whole life cash accounts often paying around 5-6 per cent interest before fees, conventional wisdom has been that you could do better investing on your own in a mutual fund for the long run. I still think so, but the market’s poor showing in recent years understandably has some investors doubtful.
But before deciding that whole life is a good investment, you have to consider the policy’s fees and commissions, which are not small. By these estimates, while an agent might make 30-40 per cent of a term policy’s first-year premium, they might earn 80-100 per cent of a whole life policy’s first-year premium. That’s a big incentive to avoid whole life.
Only an expert can tell if a policy is a good deal
The key to understanding a whole life policy is the internal rate of return after taking all the fees out. But it’s not like that number is printed on your policy. Deducing it would take someone with know-how and some serious spreadsheets.
Whole life insurance may be a good idea for wealthy and young families
For wealthy families in their 30s or 40s, whole life insurance may be worthwhile as an estate planning tool because you can create an insurance trust that can pay estate taxes out of the policy’s proceeds and then pass the trust to heirs.
Consider term life insurance instead
Now that you know the pros and cons of whole life insurance, you may be thinking that term life insurance is best for you, and you may be probably right.
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