As you recall, there are two primary types of life insurance; term and permanent also called whole, life. Not only are they the most popular options, but they also happen to be the oldest forms of life insurance. Of course, insurance companies have made shopping for a policy just as confusing as the movie Inception as you dig deeper into a character’s subconscious.
But, let’s not get too far ahead of ourselves here. Sometimes it’s best to get back to basics so that life insurance isn’t as complex. And, that means explaining how term and permanent life insurance are different, as well as the advantages and disadvantages of each. Hopefully, with this knowledge, you can pick the right type of life insurance.
What is Term Life Insurance?
This type of insurance offers affordable coverage, often with a guaranteed premium. The catch? It’s only for a specified period of time. Generally, term life insurance premiums are typically lower than premiums for permanent life insurance policies. However, renewal premiums may increase over time. As such, term insurance’s lower initial premiums make it an excellent option for those who need temporary or short-term life insurance coverage.
That’s all well and good. But, how exactly does term life insurance work?
Should the insured pass away while the policy is still active, the beneficiary will receive the full face amount. After the premium guarantee period has expired, the insured can renew the policy — often at a higher rate.
Be aware that with term life insurance, there is no accumulation of cash value. And, most of the time, there are no dividends earned.
What are the Different Types of Term Life Insurance Policies?
Term life insurance has two basic types. The first is increasing the premium term, which renews and increases its premium annually. The second is level premium term, which has a fixed premium for a specific number of years and then increases in subsequent years.
The most common types of level term life insurance are;
- Yearly renewable term
- 5-year renewable term
- 10-year term
- 15-year term
- 20-year term
- 25-year term
- 30-year term
- Term to a specified age (usually 65)
Renewable term policies.
Renewal terms of one year aren’t as popular as they once were. Today, 20-year terms are most popular. Also, an applicant who is over the age of 80 cannot purchase term life insurance from most companies.
When a policy is “renewable,” it means that it continues to operate for an additional term or terms until a specific age — regardless of the health of the insured. That means if your health declines, coverage can be maintained. And, there’s no need for new underwriting.
For most policies, the premium is determined by the insured person’s age and health at the policy’s start, and the premium remains the same (level) throughout the policy’s term. Therefore, insurance premiums for 5-year renewable terms can be level for 5 years. After that, it will change to reflect a new age for the insured, and so on.
Longer-term insurance policies usually guarantee that premiums will not rise during the term. However, some don’t make that guarantee, allowing the insurance company to raise the rate throughout the policy’s term.
Convertible term policies are also available. That means the owner of the policy has the option to convert the policy into a permanent life insurance policy. Best of all? This can be done without proving their insurability.
“Return of premium.”
With most types of short-term insurance, such as homeowners and auto, if you don’t file a claim by the time the policy expires, you don’t get a refund. The reason is that you’ve received fair value for the coverage you had but didn’t need. Some insurers, though, have responded to this problem by offering term life insurance with a “return of premium” feature.
If you purchase a policy with this feature, you’re likely to pay higher premiums. You’re also generally required to keep the policy until the end of its term, or else you forfeit your return of premium benefit. Depending on the policy, the base premium may not be returned with the extra premium (for the return benefit). But in some cases, both premiums may be returned.
The Advantages of Term Life Insurance
- The price is right. If you compare term life insurance with permanent policies of the same benefit amount, you will pay a lower premium. No matter how much life insurance you buy, whether it’s a $1 million policy or a $10 million policy; term insurance will usually be cheaper than permanent insurance. In terms of the death benefit, term life is the most economical way to insure your life.
- It’s temporary. Coverage is provided by term life insurance for a set period of time. It’s a great choice for situations such as mortgages, SBA loans, and your children’s education. Most likely, a young couple at this stage in their lives does not have a large cash reserve. So, if the breadwinner were to suddenly die, this would put you in a precarious financial situation.
- Guaranteed death benefit. With term life insurance, you’ll receive a guaranteed death benefit. But its cash value isn’t built up. Additionally, the premiums will either stay flat or increase at predetermined intervals, such as after one, five, ten, or twenty years.
- Flexible and customizable. As your life changes, you will have the option to adjust your coverage through a term life insurance policy. When combined with a whole life plan, term insurance can be used as a “rider”. Imagine an individual needs $200,000 of life insurance coverage, but is unable to afford a 100% permanent policy. They could purchase a permanent insurance policy for $50,000 and a term policy for $150,000 may be an affordable option.
- Conversion privilege. In some cases, term insurance gives you the crucial protection needed while allowing you to stay within your budget. The coverage you need today-and the option of obtaining permanent coverage in the future-is available if the coverage is convertible (you may convert a term policy to a comparable cash value policy without providing any evidence of insurability).
- Simplicity. Life insurance comes in many forms. The complexity of some is greater than others. Contrary to some permanent life insurance policies and options, term life is simple to understand. A term policy is very simple- you pay your premiums and receive coverage for the term you select. In cases of permanent life insurance, there are confusing parts including cash values, policy loans, and paid-up additions. With that in mind, life insurance shoppers who want a basic policy can quickly become confused.
The Disadvantages of Term Life Insurance
- It’s not good for the long-term. The only benefit provided by term life insurance is a death benefit — and only for a specific period of time. You lose protection when the term expires. In the case of non-payment, your coverage ends as well.
- Once the contract expires, that’s it. In the event that the policy expires at midnight on December 31, and you die at 11:59 AM on New Year’s Eve, the beneficiary receives the full death benefit. However, your beneficiary will not receive anything if you pass away at midnight on January 1.
- It’s like renting a house. We often compare renting a house to buying term insurance. The house you rent may be available to you immediately, but when your lease expires, you will have to renew the lease (probably at a higher rate) or leave. Also, although you may rent the property for 30 years, you do not own its “equity” or value. With term life insurance there’s no cash value.
- The unexpected. You will pay higher premiums as you age with term insurance. As you approach your 50s and 60s, term life insurance will be a lot cheaper than if you buy the policy later on in your 20s or 30s.
- Availability. Term life insurance becomes much more difficult to obtain as you reach older ages, usually after age 65. At these ages, most life insurance companies do not offer policies. There are a limited number of them that do, and they can be expensive.
What is Permanent Life Insurance?
If you pay your premiums on time, permanent life insurance policies provide coverage for the rest of your life. In other words, your beneficiaries will receive an insurance death benefit whether you die shortly after buying it or 50 years down the road. Cash value is another key component of permanent life insurance policies, which behaves like an investment account. The cash value of your policy may be withdrawn or borrowed once it reaches a certain value.
You can also earn dividends if you have a permanent policy with a mutual life insurance company. Since the mutual life insurance company is owned by its policyholders, the profits are distributed to them as dividends — just as long as the insurer more than makes up for its expenses. These may be used to add more coverage, pay premiums, or take cash dividends.
Cash Value of Permanent Life Insurance
The cash value account grows at a rate specified in the policy each time you pay a permanent life insurance premium. A certain amount of cash value can be used as collateral by the insurer for a loan.
Since the insurance company holds the funds to cover policy loans, there aren’t credit checks or qualifications required. Also, the loan does not need to be repaid within a set timeframe.
Policy loans come with a modest interest rate, however. Furthermore, if you can’t pay back your loan plus your unpaid interest, you’ll lose your policy’s coverage. The amount of the loan will be deducted from your beneficiaries’ death benefit if you die before the loan has been paid back in full.
Depending on the policy, you can also use the policy’s cash value to pay your premiums. The cash value of your policy will lapse if its cash value is zero. As such, this option is typically only available with universal life insurance policies.
Having cash value is a benefit of permanent life insurance, as it’s refundable if you decide to give up the policy to the insurer. Due to surrender charges at the beginning of the policy, you may not receive the entire amount accumulated. Nevertheless, you could still recoup at least part of what you paid.
You should be aware, however, that the death benefit of a permanent life insurance policy, and not the cash value, typically remains intact after you pass away.
What are the Different Types of Permanent Life Insurance Policies?
Permanent insurance policies are designed to be retained for the remainder of one’s life. However, there are several differences between the types of policies. The following are some common types of permanent life insurance and their unique features:
- Whole life insurance. According to the Insurance Information Institute (III), whole life insurance is the most common type of permanent life insurance. The death benefit and premiums with this policy are typically fixed for the lifespan of the policy. Life Happens reports that whole-life policies also contain a guaranteed return rate. This means there will be at least a minimum amount of interest earned on the cash value of the policy. It’s possible, though, to receive dividends from whole life insurance policies. Dividends may be used to reduce premiums, receive as cash, or be left alone to accumulate interest.
- Universal life insurance. Life insurance policies with universal coverage are more flexible than whole life policies, according to the III. Once you accumulate enough cash value in a universal policy, you might be able to increase your death benefit or reduce your monthly premiums. However, if you use your cash value by applying it to your premiums, your policy may expire.
- Variable universal life insurance. Policies featuring variable universal life insurance usually come with an array of investment options that can increase your cash value. Investment losses can, however, lower the death benefit as well as the policy’s cash value. A variable universal life policy also offers an adjustable death benefit and premium.
- Indexed universal life insurance. With indexed universal life insurance, the interest rate on your cash value is not fixed, which could result in greater gains and losses on investments. It does come with a minimum interest rate guarantee, however.
- Final expense insurance. Whole life insurance policies are offered at a low price under titles such as final expense insurance or burial insurance. Most of these policies cover death benefits of less than $50,000, so they are quite costly per dollar covered. It’s expensive to buy a final expense insurance policy since they don’t require a medical exam or are “guaranteed acceptance,” meaning you can’t be declined. Due to the higher level of risk, the insurer must charge much higher rates.
The Advantages of Permanent Life Insurance
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- Provides coverage for your entire life. As long as the premiums are paid, cash value life insurance provides lifelong insurance protection. After your application for coverage has been approved, your policy cannot be canceled by the insurance company. And, it doesn’t matter how sick you are, your insurance is still valid.
- Cash value accumulation. Another important facet of permanent life insurance is the cash value component. This helps you grow your death benefit, as well as protects you from inflation. As a result, the cash value of your policy improves the value of your death benefit. You can also withdraw the cash value from your account to supplement your retirement income or to borrow against it. This income is not taxed if you borrow money.
- More affordable, in the long term. The costs of cash value life insurance are less than those of term insurance in the long run, despite higher initial premiums. Regardless of the health of the economy or your health, your premiums will be fixed when you purchase the policy. In the case of a renewal, your premiums will be raised, however. At the same time, the benefits of dividends are automatically available to you — if you’re a policy owner. They can be used to expand your policy or offset the cost of future premiums, or for any other purpose, you choose. However, insurance companies may not always declare dividends. And, in some cases, dividends aren’t declared.
- Flexible premium payments It’s also possible to stop making payments on some types of permanent life insurance policies and continue to receive the benefits of the policy. Depending on the policy, you may be allowed to pay higher premiums for a shorter period of time such as 5 or 10 years, then not have to pay one again.
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- Eliminates future insurability. In the event of health problems, your life insurance will remain effective. In addition, some policies offer guaranteed purchases, meaning that no matter your health status, you can add additional coverage at a predetermined time.
- Extra tax benefits. A variety of tax advantages are available with permanent life insurance. Among these are tax-free death benefits, tax-deferred cash value growth, income tax-free dividends. There are also tax-free policy loans and withdrawals.
The Disadvantages of Permanent Life Insurance
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- The death benefit and cash value aren’t completely separate features. Should you fail to repay the loan, your death benefit will be reduced accordingly. As an example, if you borrow $50,000 and you still owe the loan, your beneficiaries will receive $50,000 less, plus interest due.
- Expensive. One of the biggest disadvantages of permanent life insurance is its high cost. Sometimes, people don’t need coverage past a certain time frame. Unless you’re planning on continuing to need coverage for a long period of time, a term policy that can be converted to a permanent policy makes more sense.
- Not convertible. Permanent life insurance policies have the advantage of their longevity, but also the disadvantage of their inactivity. If you purchase a policy and eventually realize that you don’t need it, you would have already paid premiums. As such, all the money that you’ve already invested would be lost.
- Possible policy lapse. Your insurance policy might be canceled if you miss a payment or are no longer able to make payments. The cancellation of your policy could mean having to buy a new policy which may mean higher premiums.
- Complexity. Whole life insurance can also be complicated. For example, you can not stop making payments if you no longer require the policy as you can with term life. And, if you do decide to part ways with the policy, you can expect a surrender charge of up to 10% of the cash value
Term vs. Permanent Life: Policy features
With a term life insurance policy, you have the choice of policy length. What’s more, the premium usually remains the same and the premium is lower.
On the flip side, permanent life insurance provides lifelong coverage. It also accumulates cash value. And, it’s usually eligible for annual dividends.
With both types of policies, the premium generally stays the same. And, the life insurance payout amount is guaranteed.
Term vs. Permanent Life: Cost comparison
As it’s temporary and has no cash value, term life insurance is relatively inexpensive. In most cases, however, your family won’t receive a payout because you’re expected to live to the end.
Because you will get a death benefit so long as your premiums are paid, permanent life insurance rates are higher than those for term life insurance. For example, guaranteed universal life insurance might cost four times as much as a term policy with similar coverage, while whole life insurance may cost as much as ten times as much.
Can You Have Both Term Life and Permanent Life Insurance?
Your financial situation may require a certain amount of permanent coverage, as well as coverage for a specific period of time. If this is the case, you can combine term and permanent life insurance as follows:
- Permanent life insurance with a term rider: As with term insurance, a term rider gives you the option to increase coverage during times of greater financial obligations, such as paying off a mortgage, student loans, child’s education, or to replace lost income. It’s important to confirm that term riders are available for any permanent life insurance policy before you purchase it.
- Permanent life insurance and term life insurance: You can purchase a term life insurance policy alongside your permanent life insurance policy if a term rider cannot be added. The combined death benefit on these policies increases when you need a large death benefit. Generally, this costs much less than a large permanent policy.
- Convertible term life insurance: You can opt for convertible term life insurance if you’re unsure what your needs will be in the future. The term life insurance policy may later be converted to permanent insurance, without requalifying. In this case, if your health rating was lower than your previous policy’s first health rating, your permanent insurance policy would be priced accordingly. However, you should ask about the possibility of converting the policy once you’ve reached a certain age or the completion of a certain number of years.
Should You Choose Term Life or Permanent Life Insurance?
Most people, mainly families, will be satisfied with a term life insurance policy. However, in some situations, permanent coverage would be more preferable.
Term life is a good choice if:
- Life insurance is only needed when if you must replace your income temporarily. Examples would be if you’re raising children or paying off your mortgage.
- You need more affordable coverage.
- You’d like permanent life insurance but it’s out of your budget. It is possible to convert most term life policies into permanent coverage. Depending on the policy, there may be a deadline for conversion.
- You’re considering a better investment. Term life policies are cheaper than whole life policies and allow you to invest the money otherwise spent on premiums
You should choose permanent life if you:
- You wish to provide money to pay inheritance or estate taxes for your heirs. The federal estate tax will be imposed on estates worth more than $11.7 million for individuals and $23.4 million for couples beginning in 2021. Estate taxes and inheritance taxes vary from state to state.
- You have a dependent for life, for example, a child with disabilities. When you die, life insurance funds a trust to take care of your children. Set up a trust by consulting with a lawyer and financial advisor.
- Would like to spend retirement savings and still leave an inheritance or enough for final expenses, such as the cost of your funeral.
- Want inheritances to be equal. Let’s say that one or more of your children inherit your business or property, life insurance can provide compensation to the others who didn’t receive this inheritance.
