What Is The Difference Between Term And Whole Life Insurance

| August 15, 2012 | 1 Comment
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Difference Between Term And Whole Life Insurance

Term and Whole Life Insurance policies serve different purposes (although they fall under life insurance) with regards to the financial requirements of the insured. Before we get into highlighting the differences between these two, let us first understand the basic concept “Which one should you buy? Term Insurance or Life Insurance.

 

 

Term Life Insurance Policy (Basic Purpose): Term life insurance policy protects your family for a specific and predetermined period of time (term of the policy ranges between 5 to 30 years). If due to unforeseen circumstances you die, your beneficiaries (most probably your family) will get the payment which is also known as the face value. If you survive the entire term of the policy then there is no payout. A term plan can be termed as the purest form of insurance as it does not have any cash value (discussed later in this article) or savings feature associated with it. The entire premium paid by the insured goes against the morality charges.

Whole Life Insurance Policy (Basic Purpose): A whole life insurance may be considered as permanent in nature due to the fact that you pay the premium each year for your entire life.There is no specific term in this policy. The premium which you pay in a life insurance policy covers your insurance cost and there is an investment aspect built into it. Hence the premium is higher than a term insurance plan. In life insurance, premium which is paid beyond the cost of insurance is invested and grows tax deferred. In whole life insurance also, your beneficiaries will get paid in the event of your death.

In this type of policy along with the death benefit, you pay extra money which is invested by the insurance company. In reality, the earnings from those investments should earn you enough to pay for your premiums. Which means after a certain number of years have gone by, your policy is paying for itself. Why I said in reality? Let me explain… the problem is that the insurance companies charge huge amount of commissions for the investment part in a whole life policy and the actual savings rarely work by the book.

Whole Life Insurance Policy is also called as Cash Value Insurance. These type of insurance plans are becoming aggressively popular due to the savings component attached to it. For the sake of understanding, let me give you an example to understand the myth behind cash value concept.

 

 

Myth Behind Cash Value Concept

Suppose you pay $100 as a premium against your whole life policy. The insurance company will purchase a $20 term insurance which is an annually renewable premium. Rest $80 is invested by the insurance company on your behalf. Now your cost of insurance each year will be higher as you grow older. Which means the $20 which you are paying as premium will increase each year unless of course you have opted for level term insurance where the premium remains the same for the entire term of your insurance.

So if your cost of insurance is going up each year, how it will affect you? Are you going to pay extra premium? and how it will affect your savings or cash value component of your insurance?

As mentioned earlier, overtime, the cost of your insurance premium will go up because as you grow older the chances of dying are more. Every month the excess amount of premium paid by you is deposited into the savings or cash value account by the insurance company. The savings account value which is being accumulated with every premium paid reaches it’s peak around the age of 65 years. After that, the cash value starts to come down, why?

In your later years of life the cost of insurance can be very steep and at one point it will cross the amount of premium which you are paying each year. So, who is going to pay the extra cost? It is you my friend, and that extra cost of premium is recovered from your savings or cash value account. Always remember the saying that life insurance is a tool and NOT an investment. You will be lured to pay a higher premium with an illusion that the insurance company will invest the extra money on your behalf so that it gives you good return. In practicality it never happens as whole life insurance is expensive and expenses incurred eat up your interest.

 

We also need to take note of the fact that if you wish to withdraw money from your cash value account later on, the insurance company will charge you 5 to 8% service tax to reduce the value further.

Now you might be thinking then where is the need of buying a whole life insurance? or Why should i buy life insurance instead of term insurance which is cheaper?

Good question, a whole life insurance policy can be used in estate tax planning where in you can set up an insurance trust to pay your estate taxes from the returns of the policy.

Many a times, most financial planners will always advice on the famous phrase which goes like this “Buy term and invest the difference”. This is not beneficial always and you have to run your own numbers and compare the results with your goals.

photo credit: Alex E. Proimos via photopin cc
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