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Infographic: Term vs Whole Life Insurance Comparison
Term vs Whole Life Insurance: Which is Better?
Whole life insurance might seem like the better choice, since you get insurance and cash value. But if you believe the stacking myth, you’re in for a rude shock.
I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years.
I’ll show you what term and whole life insurance are, how the cash value actually works, and which is right for you.
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How Term Life Insurance Works
Term life insurance is pure insurance for a set number of years.
You pay a premium for coverage, and if you pass away during that period, then the insurer pays your beneficiaries, like a spouse or kids, a set amount which is called the death benefit.
This is by far the cheapest kind of life insurance for young people.
That works well when your family depends on your income for a specific time period.
Say your children are young and you expect your youngest to become financially independent within 20 years. A 20-year policy can cover that vulnerable period without making you pay forever.
If you outlive the policy, there is no money waiting for you.
But that does not mean you wasted the premiums. You got protection during the years that your family needed it, at the lowest cost possible.
It’s no different from, say, homeowners insurance, where you don’t get anything back at the end of the year if you don’t make a claim. Nobody calls home insurance wasted if the house doesn’t burn down!
Whole life insurance adds bells and whistles, but at a cost.
How Whole Life Insurance Works
As the name suggests, whole life insurance is for your whole life, as long as you pay the required premiums!
Whole life also has cash value, which is money that accumulates inside the policy over time.
A portion of your premiums goes toward this cash value. The cash value can also have a guaranteed growth rate, usually 2% to 4% a year.
That’s similar to the interest you get in a savings account, and it’s very low if your goal is long-term wealth building.
So what’s the benefit of a cash value? You can borrow against it without canceling the policy, but the insurer charges interest on it, and unpaid debt can reduce the death benefit.
If you cancel the policy, which is called surrendering it, you receive a portion of the cash value back. This is called the cash surrender value, and it’s lower than the cash value because of high fees.
But here is the trap: cash value is never actually yours.
You can access it during your life, but you have to pay it back. If you don’t pay it back, your beneficiaries get less money when you pass away.
And if you do pay it back, the insurance company takes all the cash value after you pass away.
This is where the stacking myth comes in.
Say you have a $500,000 whole life policy with $80,000 in cash value.
When you pass away, your family typically gets just the $500,000 death benefit, not $580,000. So the death benefit and cash value don’t stack.
So does it ever make sense to buy whole life insurance?
Term vs Whole Life: Which Is Better?
For 99% of beginners comparing term vs whole life insurance, term is the better choice because most people need insurance for income replacement over a specific time period.
Term’s biggest downside is that the coverage expires after a set number of years. And buying another policy later costs more since you’re older, and your health may have worsened.
But this barely matters if your goal is only to protect your family until they become financially independent.
Whole life’s biggest downside is the combination of much higher premiums and painfully slow cash-value growth. And as we’ve seen, the cash value is basically useless.
“Buy term and invest the difference” is clearly the better strategy for most beginners.
Say, the difference in premiums between whole and term insurance is $300 per month. You buy term insurance, and invest that $300 every month in the stock market for 40 years.
That money will grow to $2.1 million, but the same money in cash value growing at 3% will reach just $271,000. And this will eventually go back to the insurance company anyway!
When Whole Life Can Make Sense
While studying for the CFP® exam, I learned that whole life insurance can be useful for specialized estate planning for very high-net-worth individuals.
But the vast majority of us do not need complex estate planning, so term life insurance provides the protection that we actually need at a much lower cost, and lets you invest more for the long term.
But even people who “buy term and invest the difference” can easily fall for a few common mistakes.
Check this out to avoid 4 beginner investing mistakes that cost investors tens of thousands over the long run, so you can make the most of your investments: 4 Beginner Investing Mistakes That Are Quietly Costing You Thousands
