Simplifying Life Insurance

July 16, 2013

Life insurance can be unneccessarily complicated, and planning for it in your 20's probably doesn't seem like a priority. Even if you won't need it for another 30 years, understanding the ins and outs of life insurance early on can help you make important decisions in the future.

First, to the basics. Every life insurance policy is either "term" coverage or "whole" coverage. Term coverage offers the standard benefits paid to your beneficiaries after you pass in a fixed payout. It’s pure and simple “no frills” insurance. Whole life policies are a little different. They provide the same basic benefits as term coverage, but also add an investment component that enables your policy to build value over time (ultimatley getting you more coverage). 

Now down to the nitty-gritty...

Term Life
Term life policies typically require lower payments than whole life policies, and they're generally less complicated to understand. The payments you make for your term policy ensure that your beneficiaries will get the specific amount of death benefits you're insured for if you die while the policy is in effect. The goal of a term life policy is to protect your family just enough to get them through the financial disruption of an unexpected death.

Term policies always have a set time period and they expire on a given date. Usually they last for 10, 20 or 30 years, although the policy will lapse if premiums are not paid. A term life insurance policy is a contract between you and the insurance company. You pay the premiums for the duration of the policy, and the provider keeps up their end of the bargain by promising to pay the death benefits if you die before the policy ends. In other words, term life is only worth something if you die while it is in effect. This is the main reason that it is less costly than whole life insurance.

Whole Life
Whole life insurance, on the other hand, guarantees your beneficiaries benefits from your policy for as long as they live. Unless you cash in your policy or fail to pay your premiums, your beneficiaries will always be entitled to benefits. On the downside, whole life policies require that you pay premiums for life.

Whole life policies provide a fixed death benefit just like term life policies do, but the cash value of whole life policies—sometimes called the 'investment component'—also builds over time, even though your payments stay the same. Because of this, whole life premiums are higher than term life premiums, but they do generally remain fixed over time.

Like term life, whole life policies are essentially contracts. With whole life, you hold up your end of the bargain by paying your premiums for life. The company holds up their end of the bargain by paying out your death benefits, no matter what. They also allow you to borrow against the policy while you're still alive without being taxed, although that changes the cash value of the policy.

The real question is, which option is right for you?
Term life is great for people who need the highest death benefit for the lowest cost for a specific period of time. Parents with small children are a great example, because generally they are concerned with making sure their children are protected through the college years or until the family home is paid off. Once they get past this more vulnerable stage and their children are independent, they may no longer need the coverage and they could choose to drop the insurance or shop around for different policies.

For those with serious health problems, whole life insurance may be the best option. If you are approaching your final years, you might find it difficult or impossible to get a new policy when your term life insurance expires, so don't take that risk. Instead, maintain a whole life policy and make the payments so you will always have insurance, no matter how poor your health. Be wary though - whole life insurance carries a lot of costs. Because whole life is so much more expensive than term life insurance, it is common for consumers to opt for an affordable policy that doesn’t carry a sufficient death benefit to meet their needs.

Still, whole life insurance can be a good idea for people who earn a healthy income and are not investment-savvy. In these cases, a whole life policy functions not only as insurance but also as an automatic savings account as the cash value grows year by year.

Don't let the term life versus whole life debate frustrate you. Study up, ask yourself some basic questions, and don't be afraid to consult with a financial expert who can explain the fine print.

This post was written by Karla Lant, a life insurance writer for The Simple Dollar. Lant has dealt with related regulatory issues in her work as an attorney and has researched and published on life insurance and estate planning. She has also taught subjects related to life insurance as an adjunct professor – she is currently an adjunct professor at Northern Arizona University.

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