Whole Life vs Term Life Insurance: Which One is Better
If you have dependents that need your income in order to live, then you probably need life insurance. For most people, term life is the best way to insure one’s life. It is affordable and provides the flexibility to terminate the policy without penalty when coverage is no longer necessary for you.
I frequently point out the irony that insurance is…
A product bought by people who don’t want to use it, sold by people that hope they never do.
Despite this unique characteristic, we need insurance to protect us from financial loss that exceeds our capacity to recover on our own steam.
This is especially true for life insurance.
The primary purpose of life insurance is to replace the income or other financial value someone generates for a dependent or group of dependents.
Traditionally, it serves to replace the income of a parent or spouse for the benefit of his or her spouse and children should an untimely death occur.
For centuries, widows and orphans were greatly pitied, not just for their loss of loved one(s), but for the incredibly challenging financial circumstance it left them in.
In economies so dependent on labor and trade, single-parent homes would have been a tough, tough way to maintain a family.
Thankfully, someone thought of life insurance and we have a way to mitigate such a risk today.
Who Needs Life Insurance?
To be clear, not everyone needs life insurance.
If you have no dependents, then there is no one who requires the replacement of your income after your death.
There are options to utilize life insurance for the sake of generosity if you so choose, but life insurance is in no way a necessity for you.
However, if you have dependents and no other way to fill in the loss of income through extensive wealth, then life insurance is a responsible and mostly affordable way to protect those who need you.
You may also need life insurance for any persons who generate value in other ways for your dependents.
Most commonly, this would be a spouse who doesn’t work outside the home but performs tasks that would be costly to replace like childcare or general housekeeping.
I’m only taking the time to clarify this because the insurance industry is more than happy to market and sell life insurance to nearly anyone with a pulse.
Unfortunately, as insurance companies have grown more creative over time, the tendency to sell insurance products that aren’t necessary and/or financially responsible has grown as well.
According to the 2020 LIMRA Insurance Barometer Study, some 51% of insured individuals had some form of permanent insurance while only 33% were using term life.
Truthfully, very few people will have a better outcome with whole life vs term life as we’ll see below.
In short, you need to know what options are out there to make the best choice for you and your family.
In this post, we’ll compare two of the primary types of life insurance: permanent and term life insurance, and when each is appropriate.
Whole Life vs Term Life: How Much Do I Need?
It depends on how much you need to replace.
This isn’t a really easy question to answer and the real rub is you’ll probably need a lot more in the early stages of a policy than you’ll need later in life.
So, what you need today won’t be the same amount that you need years from now, but with insurance, you usually have to buy for the long term and choose a benefit amount when you set it up.
Begin by identifying how long you’ll need coverage. Consider things like how old your children are or how long it will be before your beneficiaries could receive other income in the event of your death.
Second, consider how much debt you have. You’ll want your coverage to basically eliminate those debts if your beneficiaries would have any trouble making payments.
Third, you need to calculate your annual expenses. This is a good opportunity to remind you to go check out our budgeting post if you haven’t already.
Your dependents will need some amount of income to cover those expenses. Knowing just how much that will be will be necessary for calculating a coverage amount.
Next, you need to consider whether or not the benefit should cover expenses associated with college or another post-high school education for your children.
You may have this well handled in some other savings vehicle, but if not, you could add some coverage in your life insurance for it.
Finally, what standard of living do you want to provide? If you are young and healthy, you will likely find that term life insurance is very affordable.
BONUS STEP: Forecast your overall net worth for years to come. This can provide some great insight into how your needs may change over the years.
If it looks like you’ll have millions of dollars saved in 20 years then maybe you don’t need a 30-year policy.
Personally, I didn’t want Lisa to have to worry about money at all if I died young. So, as you’ll see below, we bought more coverage than we technically needed.
If you’re really impatient and just want to chance it with a rule of thumb, here are some common ones:
- Calculate your coverage amount by multiplying your annual expenses by 20
- Get 10x your annual income, then add $100k for each kid
- Multiply your annual income by 15, 20, or 30 (depending on who you ask)
I’d take the long route and evaluate all the debts, income, and other expenses to arrive at a number you’re comfortable with, but these rules of thumb aren’t a bad starting point.
Whole Life vs Term Life: Term Life
As the name implies, term life insurance is purchased for a period of time or a “term” of one’s life.
Policies are issued for coverage at a specified benefit amount over a period of years. Usually, the term of the policy will be anywhere from 10 to 30 years, though there are some 40-year plans available.
The monthly premium is calculated based on the insured’s age, gender, lifestyle (including their occupation), and overall health, as well as the term length.
The older and less healthy the insured, the higher the premium will be. The cost would increase as the term period is extended and/or the benefit amount is increased.
In most cases, term life insurance is the simplest and least costly way to insure someone’s life. In all likelihood, it’s all you’ll ever need.
As you set out to procure term life insurance, you should shop around for the best combination of price and benefit. The term lengths are typically decades-long, so you’ll be carrying this expense for some time.
Whole Life vs Term Life: Permanent Life
Permanent Life Insurance is a life insurance product that does not expire. There are three basic types, Universal, Variable, and Whole, all of which usually contain a savings component.
The savings piece in whole life policies grow at a guaranteed rate while universal and variable policies will grow according to market performance.
There are circumstances where permanent policies make good financial sense, but these products have been repackaged and oversold for the most part because they are exceptionally profitable for insurance companies.
In the event that someone who is without a sufficient source of retirement income is dependent upon another’s income which cannot be replaced otherwise in the event of their death, a permanent policy might make sense.
For example, suppose Jack & Dianne are retired. Dianne never worked outside the home and has always depended on Jack who is the sole breadwinner in their family.
As it happens, Jack is a retired teacher from a district that opted not to withhold social security from Jack’s paycheck throughout Jack’s career. As a result, neither Jack nor Dianne will have any social security income in retirement.
Jack and Dianne also weren’t able to save much for retirement, but along with Jack’s pension, they have enough to cover their regular expenses.
Unfortunately, there are no survivor benefits associated with Jack’s pension. This means if Jack dies before Dianne, she will only have the small retirement account to live on in the years after her husband’s death.
Given that Jack is older than Dianne, that men typically die before women of equal age anyway, and there is no other sufficient source of income, Jack and Dianne are prime candidates for a permanent life insurance policy.
This combination of circumstances, or any like it, would be somewhat rare. Given this, plus the overall cost of permanent life insurance compared to term, you’ll begin to see why you probably don’t need it.
Nearly always, you would do better to buy term, invest the difference, and self-insure after the term policy runs its course.
At the very least, if you’re tempted to buy a permanent policy, consult with someone that doesn’t have a monetary interest in selling you the policy before signing up for one.
Case Study: Curt’s Life Insurance
Earlier in 2022, Lisa and I found that the term insurance we had first purchased 10 years ago was no longer adequate to replace our income and standard of living.
Since term life insurance is cheap, we knew we could afford more coverage so we decided to buy it.
Our kids are 8 and 10. In ten years, they’ll both be out of the house and probably in college. By that time, we should easily have enough saved for college and enough to cover living expenses should one of us pass earlier than expected.
As a result, we wanted life insurance to carry us through 2032 in an amount totaling $1.5M in coverage. We were already halfway through a 20-year, $750k policy.
After checking the options, it was cheaper to drop the old policy and start a new 10-year term instead of buying a second $750k in coverage.
We never once considered a permanent policy.
However, for kicks and giggles, I reached out to my insurance company to see how much a permanent policy would be. They were kind enough to provide a price.
A comparison of the options we were given follows:
Whole Life Policy | Term Policy | |
Benefit Amount | $1.5 Million | |
Coverage Term | Lifetime | 10 Years |
Monthly Premium | $1,266.61 | $54.15 |
When I said permanent life insurance was expensive, I wasn’t kidding, but even I didn’t expect this.
On the surface, you might be repulsed by this enormous difference in premium, but bear in mind the insurance company is guaranteeing the $1.5M payout. All I have to do is die one day.
This outcome seems likely.
You’d need to invest quite a bit to accumulate $1.5M, even if you have 37 years to do it. The insurance company is simply setting a monthly payment to eventually cover the cost of the insurance payout.
With that said, the premiums would be even higher if I elected to cram them into a defined period of 20 years or up to a certain age, like 60.
In order to fully evaluate the value of each policy, I calculated the total for all premiums paid over the expected life of the policy which is another 37 years or my expected mortal age of 78.
Whole Life Policy | Term Policy | |
Benefit Amount | $1.5 Million | |
Coverage Term | Lifetime | 10 Years |
Monthly Premium | $1,266.61 | $54.15 |
Age at Inception | 41 | |
Life Expectancy | 78 | |
Total Number of Payments | 564 | 120 |
Total Amount Paid in Premiums | $714,368.04 | $6,498.00 |
Again, the costs are vastly different, but remember that a term life policy is unlikely to ever receive a claim. In this scenario, I would have to die before my 52nd birthday for the policy to pay out.
At least if I bought the whole life policy, I’d be assured the $1.5M payout.
But what if we took the difference in premiums and invested it instead? After all, that is the opportunity cost of purchasing a whole-life policy instead of term.
Below you’ll see the expected value if we invested the $1,212.46 difference between the monthly premium for whole life vs term life for ten years.
After ten years, we can direct the entire $1,226.61 monthly payment that would be going to whole life premiums into investments of our choice.
With the 10.67% rate or return we normally utilize for these time value forecasts, here’s how they compare over time.
Whole Life Policy | Term Policy | |
Benefit Amount | $1.5 Million | |
Coverage Term | Lifetime | 10 Years |
Monthly Premium | $1,266.61 | $54.15 |
Age at Inception | 41 | |
Life Expectancy | 88 | |
Total Number of Payments | 564 | 120 |
Total Amount Paid in Premiums | $714,368.04 | $6,498.00 |
Value After 5 Years | $1,500,000.00 | $1,596,420.33 |
Value After 10 Years | $1,500,000.00 | $260,419.14 |
Value After 20 Years | $1,500,000.00 | $1,025,434.96 |
Value After 30 Years | $1,500,000.00 | $3,238,604.07 |
Value After 37 Years (Life Expectancy) | $1,500,000.00 | $6,970,967.89 |
In summary, in the range of 10 years and one day up to 23 years and 3 months, the permanent policy is a better value.
Said another way, if I died between my 51st birthday and when I turn 64 years and 3 months old, the whole life policy would have been the better way to go.
I can’t see the future, but I think I can make it past 64 and the mortality rate suggests that I will. Let’s hope so.
After 23.25 years, the value of the money invested from using a term policy eclipses the benefit of the whole life policy which is always $1.5M.
We didn’t even deduct the amount paid in premiums for the whole life policy, but we also aren’t accounting for taxes due on the investment returns from the term life savings.
Another check on the side of investing the difference from using the term policy is the flexibility you have with the money. Obviously, it’s better that you don’t have to die to get access to it.
This is an individual illustration, but the quoted amounts are real. I suspect you will see similar outcomes for a broad spectrum of circumstances because permanent policies are just more expensive to own, period.
As we said, there are occasions where a permanent policy might make sense, but they are certainly the exception and not the rule. Please don’t buy one of these unless you really need it.
Conclusion
I wanted to add just a couple of thoughts to close out our whole life vs term life comparison.
First, keep in mind that life insurance proceeds are typically tax-exempt. You probably knew that, but it’s an important consideration to keep in mind.
Second, there are some very interesting life insurance strategies that ultra-wealthy people could consider for estate tax avoidance and/or charitable giving. I’m not going to cover them in detail here, but you might be interested to know such strategies exist.
Next, don’t skimp. A term life premium is a small price to pay to protect your loved ones. You typically get what you pay for and you don’t want to get ripped off buying life insurance that doesn’t pay out.
Finally, you might look at the total amount paid in premiums for the whole life policy after 37 years ($714,368.04) and assume the insurance company would never make enough to cover the $1.5MM policy.
Well, the thing is, they don’t just stash your premium under their mattress. They go invest it in securities and earn interest on it so when you die they have enough to cover the benefit and still realize a tidy profit.
Why let them invest your money and keep the earnings when you can do it yourself? Go get a term policy unless you have no other choice.
FAQs:
But doesn’t a whole life policy have cash value?
Yes, but in the event of your death, the benefit is reduced by the cash value amount.
As an investment, whole life doesn’t compare to investing the premiums on your own. As a result, we left cash value out of the evaluation for this post.
Do I have to have a medical exam for life insurance?
Usually, you do, but there are companies that will provide coverage without an exam.
You will likely still have to complete a medical questionnaire among other evaluations to determine your risk class.
How much is the sales commission for a whole life policy?
A common estimate is that the agent’s commission for selling a wholelife policy is equal to the first year’s premiums.
Can I terminate a whole life policy?
Yes, but it is typically very costly to do so.
