Term insurance is designed to meet temporary needs. It provides protection for a specific period of time (the "term") and generally pays a benefit only if you die during the term. This type of insurance often makes sense when you have a need for coverage that will disappear at a specific point in time. For instance, you may decide that you only need coverage until your children graduate from college or a particular debt is paid off, such as your mortgage.
In contrast, permanent insurance provides lifelong protection. As long as you pay the premiums, and no loans, withdrawals or surrenders are taken, the full face amount will be paid. Because it is designed to last a lifetime, permanent life insurance accumulates cash value and is priced for you to keep over a long period of time.
It's impossible to say which type of life insurance is better because the kind of coverage that's right for you depends on your unique circumstances and financial goals.
Explore the other parts of this section to learn more about term and permanent insurance and the pros and cons of each.But remember, the best way to figure out the amount and type of life insurance that makes sense for your particular situation is to meet with a qualified life insurance professional
Term
As the name implies, term insurance provides protection for a specific period of time and generally pays a benefit only if you die during the "term". Term periods range from one year to thirty years, with twenty years being the most common.
One of the biggest advantages of term insurance is its lower initial cost in comparison to permanent insurance. Why is it cheaper when initially purchased? Because with term insurance, you're generally just paying for the death benefit, the lump sum payment your beneficiaries will receive if you die during the term of the policy. With most permanent policies, your premiums help fund the death benefit and can accumulate cash value.
Term insurance is often a good choice for people in their
family-formation years, especially if they're on a tight budget, because
it allows them to buy high levels of coverage when the need for
protection is often greatest. Term insurance is also a good option for
covering needs that will disappear in time. For instance, if paying for
college is a major financial concern but you're pretty sure that you
won't need life insurance coverage after the kids graduate, then it
might make sense to buy a term policy that'll get you through the
college years.
But what happens if you buy a term policy only to realize at the end of the term that you still have a need for life insurance? Well, it's sort of a good news, bad news story. The good news is that many policies will give you the option to renew your policy when you reach the end of the term. The bad news is that you'll probably face much higher costs since age is one of key factors used to determine life insurance premiums. To renew the policy, you also may have to present evidence of insurability (that's insurance jargon meaning, "take another medical exam and answer a new round of questions about your lifestyle, health status and family history"). If you're still a fine specimen with healthy living habits, you might re-qualify at a reasonable rate. But if your health has deteriorated, you may find that with continually increasing premiums it's too expensive to renew your policy or you may not even re-qualify.
So if you're considering a term policy, make sure you carefully consider
how long you'll need the coverage. If you're pretty sure that your needs
are temporary, then term insurance may be an excellent choice. But if
you think there's a real possibility that you might need the coverage
for a long time, then remember that if you want to renew your term
policy after it expires or buy a new term policy at that time, your age,
health status or other factors may make coverage very expensive.
To better understand term insurance, consider this analogy. When you
purchase term insurance, it's sort of like renting a house. When you
rent, you get the full and immediate use of the house and all that goes
with it, but only for as long as you continue paying rent. As soon as
your lease expires, you must leave. Even if you rented the house for 30
years, you have no "equity" or value that belongs to you.
One exception to this rule is what's called a return-of-premium
term policy. With these policies, if you keep the policy in force for
the entire term, say 20 years, the insurance company will refund the
premium payments you made over that 20-year period. Of course, there is
a price to be paid for this added benefit. The premiums for
return-of-premium policies are considerably higher than premiums for
standard term policies. The price difference can be 30%, 40% or more.
Another factor to consider is that term insurance rates have dropped
considerably over the past decade, mostly because people are living
longer. If you own a standard term policy, there's really no harm done
in dropping that policy in favor of a newer and cheaper term policy. But
if you own a return-of-premium policy, dropping the policy before the
full term has expired means that you will have paid a high price for
your term insurance coverage and the premiums you paid won't be
refunded.
Another provision that is very important is something called convertibility. This valuable feature is usually available in the first few years of the policy, and allows you to convert your term policy to a permanent policy (e.g., whole life insurance) without submitting evidence of insurability. Being able to convert to a permanent policy is a great option to have in the event that circumstances in your life change such as failing health or maybe just the realization that coverage is needed for a longer period of time than you originally anticipated. That's why when purchasing a term policy, it's never a bad idea to find out what kind of permanent policies are offered by the company you are considering. Some companies may only have strong term insurance offerings, while others may have very competitive products in both categories.
One final piece of advice. Here are some important questions to ask yourself when considering the purchase of a term policy:
- How long can I keep this policy?
- If I want the option to renew the policy for a specific number of years or until a certain age, what are the terms of renewal?
- When will my premiums increase? Annually? Or after a longer period of time, such as five, ten, or twenty years?
- Can I convert to a permanent policy? If so, how many years will this option be available to me and will I need a medical exam if I want to convert?
Permanent
Permanent insurance provides lifelong protection. As long as you pay
the premiums, the death benefit will be paid. These policies are
designed and priced for you to keep over a long period of time. So if
you don't intend to keep the policy for the long term, this may be the
wrong type of insurance for you.
Why would someone need coverage for an extended period of time? Because
contrary to what a lot of people think, the need for life insurance
often persists long after the kids have graduated college or the
mortgage has been paid off. If you died the day after your youngest
child graduated from college, your spouse would still be faced with
daily living expenses. And what if your spouse outlives you by 10, 20 or
even 30 years, which is certainly possible today. Would your financial
plan, without life insurance, enable your spouse to maintain the
lifestyle you worked so hard to achieve? And would you be able to pass
on something to your children or grandchildren?
Another key characteristic of permanent insurance is a feature known as
cash value or cash-surrender value. In fact, permanent insurance is
often referred to as cash value insurance because these types of
policies can build cash value over time, as well as provide a death
benefit to your beneficiaries.
Cash values, which accumulate on a tax-deferred basis just like assets
in most retirement and tuition savings plans, can be used in the future
for any purpose you wish. If you like, you can borrow cash value for a
down payment on a home, to help pay for your children's education or to
provide income for your retirement. When you borrow money from a
permanent insurance policy, you're using the policy's cash value as
collateral and the borrowing rates tend to be relatively low. And unlike
loans from most financial institutions, the loan is not dependent on
credit checks or other restrictions. You ultimately must repay any loan
with interest or your beneficiaries will receive a reduced death benefit
and cash surrender value.
If you need or want to stop paying premiums, you can use the cash value
to continue your current insurance protection for a specified time or to
provide a lesser amount of protection covering you for your lifetime. If
you decide to stop paying premiums and surrender your policy, the
guaranteed policy values are yours. Just know that if you surrender your
policy in the early years, there may be little or no cash value.
With all types of permanent policies, the cash value of a policy is
different from the policy's face amount. The face amount is the money
that will be paid at death or policy maturity (most permanent policies
typically "mature" around age 100). Cash value is the amount available
if you surrender a policy before its maturity or your death. Moreover,
the cash value may be affected by your insurance company's financial
results or experience, which can be influenced by mortality rates,
expenses, and investment earnings.
Types of Permanent Insurance
"Permanent insurance" is really a catchall phrase for a wide variety of
life insurance products that contain the cash-value feature. Within this
class of life insurance, there are a multitude of different products.
Here we list the most common ones.
If you're the kind of person who likes premiums that will remain fixed
and predictable over time, you may want to consider:
Whole life or ordinary life. This the most common type of permanent
insurance. It provides you with the certainty of a guaranteed amount of
death benefit and a guaranteed rate of return on your cash values. And
you'll have a level premium that is guaranteed to never increase for
life.
Another valuable benefit of a participating whole life insurance policy
is the opportunity to earn dividends. While your policy's guarantees
provide you with a minimum death benefit and cash value, dividends give
you the opportunity to receive an enhanced death benefit and cash value
growth. Dividends are a way for the company to share part of its
favorable results with policyholders. When you purchase a participating
policy, it is expected that you will receive dividends after the second
policy year - but they are not guaranteed. Dividends, if left in the
policy, can provide an offset (and more) to the eroding effects of
inflation on your coverage amount.
Variable life. This type of insurance is offered via a prospectus and
provides death benefits and cash values that vary with the performance
of a portfolio of underlying investment options. You can allocate your
premiums among a variety of investment options offering different
degrees of risk and reward: stocks, bonds, combinations of both, or a
fixed account that guarantees interest and principal. This type of
insurance is for people who are willing to assume investment risk to try
to achieve greater returns. With variable life you're shifting much of
the investment risk from the insurance company to yourself. Good
investment performance would provide the potential for higher cash
values and ultimate death benefits. If the specified investments perform
poorly, cash values and death benefits would drop accordingly.
While some people like the predictability of fixed premiums, others
prefer adjustable premiums because they like having the option to make
higher premium payments when they have extra cash on hand or lower ones
when money is tight. If you find this kind of flexibility appealing, you
may want to consider:
Universal life. This type of insurance is offered via a prospectus and
allows you, after your initial payment, to pay premiums at any time, in
virtually any amount, subject to certain minimums and maximums. You also
can reduce or increase the death benefit more easily than under a
traditional whole life policy. With universal life, you get the
certainty of a guaranteed minimum amount of death benefit, as long as
premiums are sufficient to sustain that death benefit. Any guarantee
relies on the claims paying ability of the issuing insurance company. As
such, do your homework and select a financially sound company. Most
universal life policies will also provide a guaranteed rate of return on
your cash values, with one important exception. It is possible that you
will not accumulate any cash value if any, or all, of the following
circumstances occur: administrative expenses increase, mortality
assumptions are changed, the insurance company's investment portfolio
underperforms, premium payments are insufficient.
Variable Universal Life. This type of insurance is similar to universal
life. It is a flexible premium, permanent life insurance policy that
allows you to have premium dollars allocated to a variety of investment
options, including a fixed account. The policy generally provides income
tax-free death benefit, has a cash value that grows tax-deferred, and is
accessible through policy loans and/or withdrawals. Note that loans and
withdrawals will reduce the death benefit by the outstanding loan amount
plus any interest. The policy allows for increase or decrease of the
policy coverage and premium changes to the life insurance benefit
option. Some companies also give you the option to guarantee the death
benefit with the Guaranteed Minimum Death Benefit Rider. Overall,
variable universal life can be a good option for people who want to
combine life insurance with a higher potential for investment return at
a higher risk, of course. For more complete information, be sure to
always request the appropriate product and fund prospectuses as they
contain information you need to consider such as the investment
objectives, risks, and charges and expenses of the investment.
