A Life Insurance Primer for Newbies

Life insurance is boring. Who wants to curl up at night and read the fine print of a life insurance policy? Nobody normal that’s for sure.

Still, if other people rely on you financially, there’s no topic more important. This is true for healthy people and even more important for people who face health challenges.

Fortunately, it really isn’t that difficult to understand. Boring, yes; but complicated, no.

You pay premiums to the insurance company in exchange for a promise they make to pay your family a sum of money in case you die. That’s it.

If you kick the bucket, your heirs can take that lump sum and invest it in order to provide income. So life insurance protects your family because if you buy enough of the stuff, your beneficiaries can invest it and replace the income you can’t bring home anymore because you are too busy being dead.

As I said, the basics of life insurance are simple. The trick comes in when you consider the various types of life insurance and determine which is the best way to go. In my opinion, that isn’t too much of a brain teaser either. I think you’ll see why shortly. But first, let’s dig into the different kinds of policies.

The Two Types of Life Insurance

There are two types of life insurance: temporary and permanent. Term life is temporary. Whole life, universal life and variable universal life are examples of permanent insurance.

Term insurance is like car insurance in some ways. You have it as long as you pay for it. When you stop paying the coverage goes away.

When you sign up, you know exactly what your premiums are going to be and for how long. You also know what the death benefits are and how much your family gets if you pass away. So if you buy a 20-year term life insurance policy, your premium payments are fixed for 20 years and if you die during that 20-year period your beneficiaries get the jackpot — but once you stop making payments the coverage ends. Die one day after your policy lapses and you get zilch.

Permanent insurance is very different. It is designed to be with you your whole life — hence the name. Your premiums are far higher than term insurance. A part of that bigger premium goes to create a savings known as cash value. The insurance company takes that extra money and invests it for you to create and grow that cash value. In theory, the cash value grows over time and one day you can either use that money to actually make the premium payments instead of writing a check or use the cash value for any other reason you like.

If you buy whole life, the investment is super conservative. The cash value grows at a fixed rate for the entire period. With universal life the return you get varies from year to year based on how much the insurance companies earns on the cash value. If it’s variable life, the insurance company buys mutual funds for you. That means the annual return and the entire cash value varies. In other words, the cash value itself goes up and down with the market.

The big selling point for permanent life insurance is that it theoretically stays with you your entire life so it pays off no matter how old you are when you die. Also, the salespeople will tell you that the cash value acts as a forced savings and is a great tax advantaged investment. Neither of these arguments hold water in my experience. And if you are interested in buying the most life insurance for the buck and providing as much protection for your family as possible term life insurance is absolutely the way to go. I say this for two reasons:

  1. Price. Term is far cheaper than whole insurance. In fact, it can be 1/7th the cost of the permanent life or less. That means if you are most concerned about protecting your family, you’ll get a hell of a lot more coverage with term than permanent insurance. Permanent insurance is so expensive that people tend to dump it as soon as they figure out that they can save a boat load of money using term.
  2. Costs. Remember we spoke about cash value? That’s the entire argument insurance agents make when they are trying to sell permanent life insurance. The problem is the insurance companies charge you big time for the priviledge of investing your money. There are all kinds of costs, commissions and fees buried deep inside the fine print of that permanent life insurance policy. But you can easily avoid those costs. Just buy term and take the money you save and invest it yourself. You could shave 70% off those costs at least.

There is a place for permanent life insurance in the world. It’s a great tool for certain business transactions and to protect against estate tax. And depending on your situation, it might be a better choice for you. But if your main goal is to spend as little as possible to get the most protection you can, term is a great choice.

This post was written by Neal Frankle. He is a Certified Financial Planner in Los Angeles and an avid blogger over at Wealth Pilgrim and MCMHA.

Photo Credit: David Hilowitz

Comments

  1. 3

    says

    Well done Neal.

    People rarely get this kind of objective advice regarding life insurance. Most life insurance agents are under intense pressure from their firms to sell the more expensive whole/universal life, whether it’s the correct fit for the client or not.

    • 6

      says

      I think there are a few rare cases. Paying estate taxes is one good consideration. Also, to replace alimony is another. It’s a case by case situation but in too many of those cases, the reason the agent is pushing whole life is NOT for the benefit of the client.

  2. 7

    DrewShock says

    Len, I have a whole life policy that would definitely cover my burial if need be. I got the policy in my early twenties so it’s fairly inexpensive. Since I’m not married and have no kids I don’t need it for income. In fact the policy can pay for itself with the interest it gains if the Fed didn’t keep the interest rates so low. However, I still pay in full which buys extra insurance. It does have a cash value. If I had term all those years there would be no cash value. Now would I have been better off investing the difference over the years with term instead of whole? It’s hard to say. Plus my premium stays the same no matter what.

    • 8

      Len Penzo says

      I got sucked into buying a whole life policy when I was still in college … in fact, I think I was 21 years-old. A few years later I eventually realized the mistake I made and let it lapse. I then bought a 30-year term policy to replace it — even though I wasn’t married or had any kids. I’ve been making payments on the term policy ever since. It expires about 6 years from now, when my youngest child is 20 — which is pretty good timing as far as I’m concerned.

  3. 9

    says

    Very good writeup.

    Term is what I have and, given your description, what I think I’ll stick with. If there comes a point when I’m contributing all I can to my 401k, IRA, 529, and HSA (did I forget anything?), then I’ll look into whole life as another tax-advantaged way to stash cash. Until then, I’m not sure I get the point.

    • 10

      says

      Cool beans. I think even when you get to that point, you’ll see that whole life ain’t worth it for you. You may be able to self-insure at that point anyway!

  4. 11

    pizza party pooper says

    OK, here’s a life insurance question I have been wondering about regarding term life.

    Over 65, my term policy is quite expensive. By now, I have more saved in investments than my term policy would pay off even if I kicked off tomorrow.

    About the famous phrase “buy term life insurance and invest the difference” … my question is … at what point do we say we have enough investment[s] to drop the term policy?

    • 12

      Len Penzo says

      Life insurance becomes less important as you get older, PPP. Since its main purpose is to ensure your family will maintain its standard of living in the event of the main bread winner’s death, most people only keep it until their youngest child has left the nest — although some folks prefer to keep it until their last child has graduated from college. By then, many folks have their homes paid off and/or enough money saved up to ensure the surviving spouse will maintain his/her standard of living even without a life insurance payout. For that reason, when my 30-year term policy is completed, I will not be getting any more life insurance.

  5. 13

    Meghan says

    I agree with you on this on principle but my Dad’s term policy expired right in the middle of his leukemia fight. Had it been whole life, my Mom would have had a lot more peace of mind. He’s still fighting, and hopefully it wouldn’t have been needed but watch out for bad timing!

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