Sunday, November 12, 2006

Comparing whole life with term insurance

Lets take a HYPOTHETICAL example of the difference between whole life insurance and term insurance in numbers. Lets say this person is 30 years old and is rated non-preferred.

Whole life:
Coverage: $100,000
Premiums: $100/month until age 100. Let's assume that $20 is used to pay the insurance and $80 goes toward cash value. In reality, cash value life insurance policies has hidden annual fees and surrender charges, so its not really $80. But to keep things simple, lets say that $80 does go toward cash value. Lets also assume that you get a 2% rate on the cash value, which is pretty realistic base on what I see from many policies I replaced. In all whole life policies, no cash value is accumulated during the first two years.
Cash value accumulated by age 60: $36,053.11

30 year Term:
Coverage: $100,000
Premiums: $20/month for 30 years
Cash value: N/A
Investing the difference...
Invest $80 @ 2%, by age 60 you will have $39,483.73. You can get 2% by saving it in a savings account or in money markets.
At 5%: By age 60, you will have $66,858.11. You can get 5% by saving it in the online savings accounts such as HSBC Direct or EmigrantDirect or in CDs.
At 8%: By age 60, you can potentially have $120,023.61. You can get 8% by investing in real estate or some conservative mutual funds.
At 12%: You can potentially have $282,393.10 in 30 years. You can get 12% by investing in large growth or aggressive growth mutual funds.

If you die during the term, your beneficiary will get death benefit plus all your investments. In whole life insurance, your beneficiary will only get the death benefit and all the cash value is kept by the insurance company. How sucky is that?

What if you outlive the term? Then you need to take a look at your financial needs. In 30 years, do you still need life insurance or as much coverage? If you invested the difference, you can potentially have anywhere from $120,000 to $280,000 in your portfolio. If your investments were in a Roth IRA, all your investments grow tax-deferred and you can withdraw your contributions at anytime without paying penalties. When you are 59 1/2 years old, you have tax-free withdrawals. (If you put it in a Traditional IRA, the only tax-free withdrawal you can take is the contributions you didn't make tax-deductible. All others will be subjected to income tax.)

Right now, you probably don't have much saved. You probably have kids, have a mortgage to pay, and some other debts. If you die tomorrow, your family will be emotionally and financially devastated. This is the time when you need most income protection and only term can provide that need for the lowest possible cost.

In the later years, your kids grow up, your mortgage is paid off, and hopefully you got your debts under control. You are nearing retirement, so you better have lots of money saved. If you have less financial obligations and have lots of money saved, do you still need life insurance or as much coverage?

You don't know what is going to happen in 30 years. If it turns out that you still need life insurance, there are several things you can do. Majority of term policies provide coverage up to age 100, but some cancel at the end of the term. You should carefully read the policy to see what would happen when the term ends. But in most term policies, you have several options you can take.

1) You may renew the term policy, but your premiums will go up each time you renew, but at least you don't have to provide proof of insurability. If you are going to renew, you should lower your coverage to the point to cover your funeral expenses.
2) You may exchange the 30 year term policy to a shorter term policy such as 20 years or 10 years. Here, you may be able to afford the current coverage amount. If not, you can always lower it.
3) You may convert it to a whole life policy. You will be fixed in the new premium for life and begin building cash value. But I wouldn't recommend it because they are complete ripoffs.
4) You may cancel the term policy by not paying your premiums. If you cancel the policy, then you should allocate more money toward your investments. If you have some debts, then apply some of the savings to the principal balance. Though, its only $20/month savings, there's really not much you can do to be productive with this extra $20.

But I wouldn't worry about what would happen in 30 years. Right now, your focus is getting the right amount of income protection and build wealth for the future.

To see a related story comparing whole life to term insurance, go here: