Life Insurance Basics
Why life insurance? Life insurance isn't a sexy topic. But if you have people depending on you for financial support and daily care, such as children or elderly parents, life insurance is a necessity.
There are two basic types of life insurance: term and permanent. Term insurance is purchased for a set period of time, say 20 years, and it's far cheaper than permanent insurance. Permanent insurance, such as whole life insurance, covers you until the day you die, and as long as you pay your premiums, you will continue to have coverage.
Not every policy is for every person. Here's a look at what's out there, and the advantages and disadvantages of both.
Term insurance is the simplest kind of insurance available. You pay a monthly premium for a certain amount of coverage -- it could be $50,000 or $250,000 or anywhere in between, or even more. You choose how long the coverage will last, such as 10 or 20 years. Coverage continues for the length of the policy, as long as you pay the premiums. Your beneficiaries would use the money to pay such items as an outstanding mortgage, upcoming college costs or basic living expenses that your salary would otherwise have covered.
For example, you could buy a $250,000 term policy for a 10-year period. Keep paying for those 10 years and if something happens to you during that time, your beneficiaries will inherit the full $250,000 face value of the policy. But if you die after 10 years and two weeks, no benefit will be paid.
With term insurance, you can buy more coverage for less money, which financial planners say is a huge advantage for young families who may need a lot of coverage, but who may not be able to afford the steep premiums of a permanent policy.
"Term is really for people who have a temporary insurance need," says Dianne H. Webster, a certified financial planner with Integrated Financial Strategies in Amesbury, Massachusetts.
Webster says, for example, parents who want to make sure their kids' college educations are paid for should something happen to the parents may want term insurance. They'd buy a policy that would expire sometime after the children would graduate college; once college is completed, they wouldn't need the coverage.
Others may want to carry enough coverage to pay for their mortgage should something happen to the breadwinner in the family. Once the mortgage is paid, they don't need the insurance anymore.
But there are disadvantages to term.
When you're in your 30s, premiums are very inexpensive, assuming you're in good health. Premiums stay level during the course of your policy. But when you get into your 50s and 60s, purchasing a new term policy can get prohibitively expensive because you are a greater risk to the insurance company. Your insurance company will probably want you to have a physical exam and take blood tests if you want to renew your policy -- just as you'll have to when you first apply. If your health has changed as you've gotten older, your premiums will get pricey or you could even be turned down for coverage when you try to renew your policy. Compare that to a permanent policy, which will cover you until the day you die, no matter what happens to your health as you age.
Another disadvantage to term is that 100 percent of the premiums you pay go into the pocket of the insurance company. That's different from permanent insurance, which has a portion of your premiums invested into a savings-type account that will accumulate over time.
Permanent insurance is also known as cash value insurance, because you build a cash value to the policy as you pay the premiums. Part of your premium pays for the insurance, and part is invested in an account that accumulates interest in your name.
"If you're not going to be a good saver on your own, this will give you a forced savings," says Karen Altfest, a certified financial planner and vice president with L.J. Altfest & Co. in New York City.
The biggest advantage is that when you buy a permanent policy, the insurance sticks with you as long as you pay the premiums. The insurance company can't cancel the policy for medical reasons.
The cash value that accumulates grows tax-deferred, and depending on the type of policy you buy, the cash value is invested in stocks, bonds or other investments. You can actually borrow from this account, or withdraw the cash value completely, though withdrawals will be taxable as regular income.
There are disadvantages to this form of insurance, too. Permanent policies are much more expensive than term insurance -- often thousands of dollars a year, versus a few hundred dollars a year for term insurance -- so most people can't afford as much permanent coverage as they can afford for term coverage. And while the permanent policy has a cash value, you might be able to invest that money better than the insurance company will.
"If you're at all an active investor, it may be better to buy the term," says Altfest. "Insurance companies tend to be very conservative with how they invest your money and you might be able to do better."
Also, the operating expenses of insurance policies are generally quite a bit higher than those of mutual funds. So buying term and investing on the side may be cheaper all around.
There are different types of permanent policies:
- Whole Life: These policies have the same premiums every year, but you don't have the option to decide how your cash value is invested.
- Variable Life: Like whole life, variable life policies have the same premiums every year, but you're given investment choices for your cash value. You can usually choose from among a batch of mutual funds, some more aggressive, some more conservative.
- Universal Life: This is the most flexible type of permanent policy. You can choose the investments for your cash value account and you can also choose what your premiums will be, as long as you pay the minimum. So if you're having a good year or a bad one financially, you can alter what you pay each year.
Which is Better For You?
That depends on your reason for buying the policy.
When you look at your overall financial picture, do you need insurance, or do you need insurance and an investment vehicle? If you solely need insurance and you're investing elsewhere, term is by far the most affordable. But if you're not a good saver, a permanent policy could be the way to go.
For more information, check out the Insurance Information Institute. Also visit the Life and Health Insurance Foundation for Education, which offers calculators to help you figure out how much insurance you need.