There are four distinct types of life insurance (and countless variations of each of the four types). The best type of life insurance for you depends upon your objectives, but most people will find that term life insurance, or sometimes whole life insurance is most appropriate. Term life insurance is the least expensive form of life insurance on an annual payment basis, and most people can afford far more coverage than they would be able to afford with other forms of life insurance.
To determine the appropriate kind of life insurance, you should ask yourself questions.
- How long do I need the coverage to last?
- Will I need the coverage to increase over time?
- How much can I afford to spend on life insurance each month/quarter/year?
- Do I want to use life insurance as a part of my investment portfolio?
- Do I have any estate planning or trust funding needs?
- Am I worried that I may have a significant decline in health during the period of my life when I need life insurance coverage?
A quick overview of each type of life insurance:
Types of Life Insurance
Term Life Insurance
Term life insurance is a temporary form of life insurance. Term will provide coverage for a specified amount of years, usually 5, 10, 15, 20, or 30 years long. Term life insurance can normally be converted to whole life at a certain point, and is sometimes renewable (for higher rates). Term life insurance is guaranteed by the life insurance company to be in place as long as the owner makes the required payments consistently on time.
Term coverage is very affordable. Most people do not spend more than about $50 a month on term life insurance coverage, and many people spend as little as $10-$20 a month. Term life insurance provides all of the protection of other kinds of life insurance for a fraction of the cost. The rates of most term policies are level, meaning that they are not allowed to rise after the policy is issued during the coverage period (prices may rise if you choose to extend, or renew the policy).
Because term life insurance provides adequate coverage for a fraction of the cost, and most people do not need life insurance after they retire, it is the most appropriate solution. For a detailed description of term life insurance, read more here.
Whole Life Insurance
Whole life insurance is a permanent form of life insurance. Whole life insurance is guaranteed to provide coverage for the policy owner for their entire lifetime, as long as they make the required payments on time. Whole life insurance is different from term life insurance because it accumulates a cash value. The cash value is like a savings account, attached as a part of your life insurance policy. Owners can take loans from the cash value, or assign it as collateral to get loans from a bank.
The cash value potentially grows in two ways. One is through dividend payments. Dividend payments are payments from your life insurance company to you each year for being an owner of whole life insurance. An owner can choose to keep these in the policy, purchase additional paid up life insurance, or take them as payments (or pay the premiums with them). Because whole life insurance pays dividends, it is considered an investment, and many people use it to supplement their investment portfolio as a conservative holding.
Whole life insurance is appropriate for people who need the coverage to last for their entire lifetime, even into retirement. Some people use life insurance to facilitate the passage of their estate to the next generation efficiently. This may be needed to pay estate taxes for heirs, or to make an estate “even” for each heir, as some assets can not be split up easily (like a valuable painting, jewelry or antiques). Some people also want to leave their children with an inheritance, and life insurance is the easiest way to ensure that they can get one.
Whole life insurance is considerably more expensive than term life insurance on an annual basis, but after a certain period of time the dividend payments can pay the entire premium, and eventually the policy will even make money for the owner. The early years of the policy are much more expensive than term coverage though.
Universal Life Insurance And Variable Universal Life Insurance
Universal life insurance and variable universal life insurance are similar products. These are complex forms of life insurance that are not appropriate for most people. These policies have a flexible payment structure, as long as the cost of insurance is met. The cost of insurance rises over time, and there are many extra fees, expenses, and taxes embedded as a part of the policies.
Any payment made into the policy in excess of the cost of insurance accumulates in the cash value.
A universal life insurance policy pays a rate of interest on the cash value (by law not lower than 2%). The rate that is paid is usually tied to LIBOR and will change annually.
A variable universal life insurance policy invest the cash value into variable sub-accounts. The accounts fluctuate according to the performance of the funds. For this reason variable universal life insurance is sold as an investment. The reality is that fees usually make variable life insurance less desirable than a brokerage account for most people.
Both of these types of life insurance are considered permanent forms of life insurance. As long as the cash value is sufficient to pay the cost of insurance, or as long as the client is paying the cost of insurance out of pocket, they will stay in force. Many people who buy these policies make the mistake of not funding them properly during the early years of the policy, and as a result they are left with a very expensive life insurance policy later in life. Do not buy a universal life or variable universal life policy unless you understand it fully.
The Right Type
To determine the right type of policy for you, we will consider that only term or whole life insurance is a valid product for your needs. Use these questions to find the type of policy that works for you. Most people will find that term life insurance is sufficient.
Do you need the coverage to last the rest of your life no matter how long you live?
If the answer is no, term life insurance is appropriate as long as you can purchase a policy that last sufficiently long.
Do I need life insurance as a conservative part of my total investment portfolio?
If the answer is no, you can use term life insurance. Most people will find that buying term and investing the difference yields greater investment results in the long run.
How much can you afford to spend on life insurance each month?
If the answer is less than $100, you are better suited to use a term life insurance policy. Whole life insurance policies can cost thousands of dollars a year in the early years of the policy.
Will you need the coverage to increase over time?
Whole life insurance policy owners can use dividends to buy paid up life insurance. In this way they can slowly increase the coverage their policy provides over time. If you do not need this feature, or if you are able to obtain additional term life insurance policies in the future, term life insurance is sufficient for you.
Do you have estate planning or trust funding needs?
Most people do not pay estate taxes. If you are likely to leave a taxable estate, or you have complex trust funding needs, whole life insurance may provide the most tax efficient solution. Always work with an accountant, trust planning lawyer, and investment advisor if this pertains to you.
Do you fear a decline in health making you unable to obtain additional life insurance coverage in the future?
If you fear that you may need additional life insurance coverage in the future, but due to a family history of disease or other concern you also fear that you will not be insurable, you may want to consider purchasing some whole life insurance. Term life insurance does expire, and if you need additional coverage or you need the coverage to last longer make sure you take this into account. Most people can obtain additional term life insurance policies in the future if needed.
Choosing the right type of life insurance can appear daunting for many people, but in reality term life insurance provides an adequate solution for most people.