Life insurance is confusing. There are so many options out there: term, whole life, universal life. Do you need life insurance? How much insurance do you need? What type of policy should you buy? I’ve been doing a lot of research on the subject lately and I want to share with you what I’ve learned.
What is life insurance?
Life insurance is an insurance product that pays a lump sum of money to someone, called a beneficiary, when you die. You can have multiple beneficiaries if you wish. The amount that is paid is based on the face value of the policy. The money transfers to the beneficiary tax free and is not considered part of your estate (for will or probate purposes).
There are essentially two types of life insurance: term life insurance and whole life insurance (also called universal life insurance).
Term life insurance is available for a certain term length, typically 10, 15, 20 and 30 year terms. You pay a level premium for the length of the term and when the term expires, you no longer have life insurance. This is like car or homeowner’s insurance with a longer term. This is the least expensive way to get life insurance.
Whole life insurance is meant to cover the insured for their entire life, as long as the premiums are maintained. The monthly premium can increase over your life. With whole life, you will pay more each month to build up cash value, which is a savings account inside the policy. This savings account can be borrowed against or used to offset the increases in the premiums as you get older. If you borrow against the cash value and die while the loan is outstanding, the amount of the death benefit will be reduced by the amount of the outstanding loan. Typically, whole life insurance is 20 times more expensive than term insurance because of the cash value that is building up inside the policy.
Who needs life insurance?
You purchase insurance because you cannot afford to pay for a loss that might occur, like the loss of a car or home. You have health insurance because you cannot afford a major medical event out of pocket. Life insurance should work the same way. You need life insurance to take care of those who rely on your income should something happen to you because you don’t have sufficient assets to take care of them if your income was lost.
Typically, we think of taking care of a spouse and young children when we think of life insurance and you absolutely need life insurance in that case if your family cannot survive the loss of your income. You should have about 10 – 12 times your annual income in life insurance so that those who are left behind can live off the proceeds if they are invested wisely. If you currently make $50,000 per year, a $500,000 – $600,000 policy invested at 10% would replace your income without touching the principle.
Another group that increasing needs life insurance is recent college graduates. More and more college graduates are leaving school with cosigned student loans. When you die, your assets would go to pay off your debts first. If there are any outstanding debts left after your assets are liquidated, the debts go unpaid. That is true unless you have a cosigner. While some student loans are being forgiven, most private loans are not. If you have a lot of private student loans, it may be wise to get life insurance to pay off your student loans should something happen to you. You can name the cosigner as the beneficiary of the policy.
If you have a large nest egg, no debt and your family would be fine financially should something happen to you, you probably don’t need life insurance. You should speak with a financial advisor to evaluate your situation. Make sure to ask questions and make sure you really understand what you are purchasing before you buy.
What type of life insurance is best?
I have always heard Dave Ramsey say that whole life was a bad choice because it was so much more expensive than term insurance. After doing my research, I completely agree with him.
I got a quote for term and whole life insurance. For a $1,000,000, 20 year term insurance policy the rate was $50.45 per month. For a $1,000,000, whole life policy the premium was $1,020 per month. Quite a difference there. So let’s say that you purchased a 20 year term policy and invested the other $970 per month. At the end of the term policy, you would have approximately $939,000 in investments. Not quite $1,000,000 but pretty close. If you let that money grow for another 20 years, you would have over $9 million. If you had purchased the whole life policy, you would have paid over $1,000 a month for 40 years and your beneficiaries would only get $1,000,000 when you die. $9 million sounds a lot better to me. Even if I’m half wrong, your beneficiaries would still get $4.5 million.
But what about that cash value that builds up? When you die, the insurance company keeps that. If you take out a loan against the cash value and you die, the amount of the loan is subtracted from the face value. Kinda sounds like you really don’t get much for that cash value, huh?
Do your homework!
Never buy anything because your investment advisor, your insurance advisor or anyone else (including me) tells you to. Do your homework! Look at all of your options and make an informed decision. I am not an insurance advisor and have based this post solely on my research. I got an insurance quote (both quotes were actually from the same company) and used an investment return calculator to see how much money I would have if I invested the difference. Your numbers might work out differently.
What questions do you have about life insurance? Do you have life insurance?