Q. What's the difference between whole life and term life insurance?
A. These are the two main forms of life insurance you should understand. (It's also good to learn about universal and variable, which are variations of whole life insurance.)
With term insurance, you're covered only during the life of the policy, while you're paying the premiums. If you carry a term life insurance policy for 50 years, regularly pay the premiums, and then quit paying and die a year later, you're out of luck. (Well, you'd be out of luck regardless -- but, in this case, your beneficiaries are out of luck, too.)
There are several forms of term insurance:
- With level term, you pay a fixed premium for up to 20 years. This can be a good deal, as it protects you against the effects of inflation and unexpected changes in your health that would warrant higher premiums.
- Annual renewable term gives you the option of renewing your policy regularly, but at increasing premium rates.
- Decreasing term policies feature a steadily decreasing death benefit. This might seem undesirable, but it can be sensible for many people. You may need a bigger benefit when you're a young breadwinner than when you're a retiree with grown children and a nice nest egg.
Whole life insurance, meanwhile, is designed to cover you for your whole life. These policies charge you a fixed premium each year, one that's typically higher than term insurance. The advantage touted by insurance companies for whole life insurance is that, while part of the premium covers what term insurance would cost, the surplus resides in an account that pays interest and accumulates a cash value. As this "accumulation account" grows, your premiums can decrease over time. Eventually, in some cases, the interest earned can pay the premiums for you. So, you won't be paying any more premiums, but you'll still be covered for the rest of your life.
The problem with whole life insurance is that insurance companies tend to offer low interest rates to policyholders, while they typically earn much greater returns because they invest the money in stocks and bonds. Policyholders are indeed earning a bit of money through the policy, but as an "investment," it leaves a lot to be desired.
Enter "universal" life insurance, a form of whole life insurance. With universal life, in years when the insurance company earns more on policyholders' accumulation accounts than they promised, they pass along the extra gain. This sounds good but, in some situations, due to overly optimistic assumptions by insurers about returns customers will earn, customers can end up paying more than they expected. "Variable" life insurance policies, which invest in sub-accounts that look like (but legally are not and cannot be) mutual funds, carry the same danger.
With universal and variable insurance, the higher the initial assumed rate of return, the lower the annual payments will be. This is how some unscrupulous agents can sign you up -- through very attractive policies based on unreasonable assumptions. Since most insurers invest to a great degree in bonds, be skeptical of any promised universal rates much higher than the 30-year Treasury rate. With variable insurance, since most mutual funds have trouble beating the S&P 500's average historical return of 10-12% per year, we'd be skeptical of any projected rates in that neighborhood.
Learn more about insurance in our Insurance Center. You may not have thought about some kinds of insurance, such as disability or long-term care insurance, but they're vital for many people. Take a little time to learn more, and you'll be happy you did if a calamity occurs in the future.
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This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.
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