Episode 228: July 26, 2011
by Laura Adams
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When it comes to buying life insurance there are many different products to choose from: term, whole, universal, and variable. What the heck is the difference between these and which type is best, anyway? Keep reading and I’ll explain the differences in plain English and give you 7 tips to figure out which type of life insurance is right for you.
Who Needs Life Insurance?
Life insurance is a contract between you and an insurance company in which they promise to pay out some amount of money if you die. Ask yourself this question: “Is there anyone who depends on my income who will be in financial trouble if I die?” If you answer “yes” then you need life insurance. I know it’s not a pleasant topic to think about, but it’s important if you have children, a stay-at-home spouse, or other family that you take care of.
Before you start shopping for a life insurance policy, you need to understand all your options. The two main types of life insurance are called temporary and permanent. Which one is best is a hotly debated topic in personal finance, so I’m going to cover the main points of each.
What is Term Life Insurance?
Temporary and permanent are the two main types of life insurance and which one is best is a hotly debated topic in personal finance.
Term or temporary life insurance provides protection for a specified period of time only, like a term of 10, 20, or 30 years. Term is the most affordable coverage because it doesn’t have any fancy features—all it offers is a pure death benefit. The price, or premium, typically stays the same each year during the term. The downside to term insurance is that once it expires the price to buy a new policy goes up as you get older.
What is Permanent Life Insurance?
Permanent life insurance, on the other hand, provides a death benefit for your entire life and it’s also an investment. A portion of each premium you pay goes into an account known as the policy’s “cash value” and it grows on a tax-deferred basis until you take a withdrawal or borrow from the policy.
The downside to permanent insurance is that it’s expensive and comes with fees and commissions that usually reduce your annual return on the investment part of the policy when compared to what you could earn in the market otherwise.
The three most common types of permanent life insurance are:
What is Whole Life Insurance?
A whole life policy gives you a guaranteed death benefit, a fixed annual premium, and a guaranteed rate of return on your cash value. Since those guarantees are locked in and can’t fluctuate, whole life is the most expensive life insurance product available.
What is Universal Life Insurance?
Universal life doesn’t offer the guarantees of a whole life policy, but it has more flexibility. The premiums are less expensive, but they can also increase up to a maximum amount. With universal life you get a minimum rate of return on your cash value, but it can grow more quickly because you have the ability to earn more when the financial markets go up.
What is Variable Life Insurance?
Variable life is similar to universal except that you choose how to invest your money from a menu of securities and funds. It offers the most flexibility and risk of all the permanent policies. There’s no guaranteed minimum rate of return; if the investments you pick perform well, your cash value could skyrocket, but if not, your cash value could plummet.
7 Tips to Choose the Right Life Insurance
Here are 7 tips to help you choose the right life insurance:
Tip #1: Consider the Cost
If your budget only allows a few hundred dollars a year for insurance, then a term policy will fit the bill. It’s better to have an affordable, short-term policy rather than no insurance at all. Permanent polices can be up to 10 times more expensive than term policies.
Tip #2: Calculate the Benefit Needed
Most people simply want to get the most payout that they can afford to insure that if they die, their family will be left in good financial shape. If that’s your goal, a term policy is probably best. A good rule of thumb for calculating the minimum amount of life insurance you need is to multiply the annual income you need to replace by 5. Also check out the life insurance calculators at lifehappens.org and Bankrate.com.
Tip #3: Evaluate How Long You Need Insurance
The longer you intend to keep a life insurance policy, the more a permanent policy can pay off. That’s because the cash value could grow large enough to compensate for the high premiums if you own it for at least 10 years and the market is doing well.
Tip #4: Be Clear Why You Need Insurance
Some people may not need life insurance after their kids are grown or once they retire, which tips the scales toward a term policy. However, if you need a policy to pay a beneficiary no matter when you die—perhaps to support a disabled child or to help your heirs—then a permanent policy is the way to go. You may want to consider having both a term and a permanent policy to address specific financial needs.
Tip #5: Assess Your Health
When you’re young and in good health, a term policy is cheap. But if your health is declining, a permanent policy may be the most affordable way to make sure that you can have life insurance for as long as you’ll need it.
Tip #6: Remember the Purpose
The purpose of life insurance is to protect a beneficiary against a financial loss, not to turn a profit. If you have money to invest, a life insurance policy isn’t the most effective investing tool. You may have heard the saying “buy term and invest the rest.” However, if you’re a poor saver, a permanent policy can be a forced savings plan that will boost your wealth if you own it long enough.
Tip #7: Use Highly-Rated Insurers
A life insurance policy is only as good as the company that stands behind it. You can check out insurer ratings and get free quotes at sites like AccuQuote, Insure.com, and MatrixDirect.
Life insurance is not a simple product, which means you need to do your homework and speak to professional agents before you buy it. Depending on your situation and financial goals, a permanent policy can be a smart planning tool or an expensive hazard to avoid.
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