What is the difference between Term Life and Whole Life Insurance?

The question of differences between term and whole life insurance, and which policy is most advantageous, sparks hot debate among many, including those in the financial industry. Each has its value, and consumers benefit from understanding both types, so they can make their own informed decisions about what type of life insurance works for their unique situation.

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Whole life and term life insurance each have variations, which is another layer of understanding for consumers. There are some key differences between these types of insurance, and understanding them will aid in defining the products best suited for any individual’s financial protection and planning.

What is Term Life Insurance?

Term insurance covers the policyholder strictly during the life of the policy, while continuing to pay premiums. Policy terms are usually 10, 20 or 30 years. One of the downsides of term insurance: say someone carries a term insurance policy for 50 years, paying for it every month, and then quits paying. If they die in year 51, they, or rather their beneficiaries will get nothing.

Types of Term Life Insurance

There are a few different types of term insurance. The first is level term life, which requires a fixed premium to be paid for up to 20 years. This protects policyholders from inflationary effects on the premium, and any unexpected health issues that might result in higher premiums.

The next type is annually renewable term insurance, which gives people the option to renew their term policy on a regular basis, but the premiums will most likely increase at each renewal.

A third type is decreasing term life insurance. The death benefit for this type of term policy steadily decreases. Although this may seem odd, many people will need a larger insurance benefit when they are young with a family to take care of, and financial obligations to pay off. Once people retire with a nest egg and children who are grown, the need for life insurance becomes less.

What is Whole Life Insurance?

Whole life insurance is a type of policy that covers an individual for her entire life. This policy charges a fixed premium to the policyholder each year, or month if that is how she chooses to pay. The premiums are typically larger than those for term insurance are. The idea is that part of the premium pays for life insurance that is similar to term insurance, and the rest of the premium is put into a savings-type account that accumulates cash value and pays an interest rate. As the value of this account grows, it can be used to cover part of the premiums on the policy. Eventually, in some cases the interest payments can completely cover the cost of the premiums, which enables the policyholder to have life insurance without a payment, and continue to have the life insurance coverage for the rest of his life.

One of the downsides of whole life insurance is the investment return. The product typically pays a rate of return that is on the low-end, comparable to an investment in bonds.

Other Types of Permanent Insurance

A few other types of permanent insurance exist, which are in the same family as whole life insurance with a few differences. Universal life insurance is one variation, with a higher rate of return passed on to policyholders from the insurance company in years when the insurer earns a surplus of money over some set amount on the cash value of the policy. Variable life insurance allows policyholders to dictate where their cash value is invested, by choosing among different sub-accounts that mimic mutual funds. Both of these types of life insurance carry some investment risk, and are subject to a hard sell by unscrupulous insurance agents. These agents usually provide a scenario for the life insurance policy’s cash value growth based on unrealistically high interest rates.

The Argument for Whole Life Insurance

Whole life insurance could be called a forced savings plan. In some ways, it is like the purchase of a home, since the payment is fixed every month, tends to be relatively expensive, and is building equity in something (the cash value.) Term insurance, on the other hand has been called “renting life insurance.” Whole life policies must be held for the long-term to create value for policyholders, and benefits such as tax-free loans on the cash value the policy can be a strategic part of retirement planning. Additionally, having higher payments while young and able to earn income is the trade-off for having enough cash value to cover the premium payments in later years, without worrying about qualifying for an insurance renewal with health that may not be as good as it was for the original insurance application. Additionally, for those who find it difficult to have the discipline, time or knowledge to save and invest their own money, this type of policy provides another way to do that.

The Argument for Term Life Insurance

Term life is a simple insurance product that guarantees coverage for a specific time period. Term insurance makes sense for families who need the cheapest price for the highest amount of coverage. Consequently, young families that do not have the resources to spend on whole life usually purchase term insurance.

Here is a typical illustration used to show the benefit of term insurance over whole life. For example, say a male, non-smoker, 40-year-old has to choose between a MetLife universal life insurance policy with a face value of $250,000 and an annual premium of $3,000, or the same amount of term life insurance. The term insurance is renewable, with an annual premium of $350, which is fixed for a 20-year period. In one year, the universal life policy, with 5.7% interest paid per year on a tax-deferred basis, would have a zero cash value. This means the person gets nothing back if they cancel the policy. If a person took the difference between the term insurance costs and the universal life costs, which would be $2,650 and put it in a no-load mutual fund averaging 10% returns annually, in the first year he would have $2,841 after taxes at 28%. In 10 years, that amount would have grown to over $46,000 in the mutual fund, after taxes. During the same 10 years, the growth of the cash value in the whole life policy would have grown only to $31,819.

The shaky part of this analysis is the assumption that somebody can get a 10% return each year for 10 years, which is not the easiest task, especially these days. It also ignores the fact that the cash value of the insurance policy is available to borrow on a tax-free basis, and that certain whole life policies also have a guaranteed minimum return on the cash value.

The best strategy is to do some homework and become familiar with the products. Many online calculators can provide premium estimates for both types of life insurance, to help consumers gain more clarity on the choice that really works for their financial needs.

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