When you purchase life insurance, you agree to pay a specific sum of money, or premium, to the insurance provider at regular intervals. The frequency or period of your payments depends on your mode of premium. Most insurance providers offer several modes of premium, the most common of which come annually, semi-annually, quarterly or monthly.
Determining Mode of Premium
The mode of premium payment is not the same as your mode of payment. Your mode of premium payment determines the frequency with which payments are made. It also determines the way in which you make payments, such as by cash, check, credit card or another option.
Policyholders select their mode of premium when they sign their policy. It is common practice to make your first premium payment to activate the coverage on your policy. The insurance agent should highlight the possible frequency of premium payments before you sign your policy.
Many insurers allow policyholders to change the mode of premium to a higher or lower frequency during the life of the policy. Dates of change normally coincide with pre-existing payment dates, meaning if you want to change from a semi-annual to a monthly premium, then you will likely make your first monthly payment on the date of your next scheduled semi-annual payment. The payment schedule would switch to monthly from that point forward.
Why Mode of Premium Matters
As a general rule, more frequent modes of premium payments tend to cost less per payment. However, more frequent payments also tend to cost more in total. For instance, an insurer might charge you $150 per month, $400 per quarter, $700 per semi-annual payment or $1,250 per year for your policy. The up-front costs of the annual payment are much higher than the others, but it is actually the cheapest mode for an entire year's worth of coverage. The monthly, quarterly and semi-annual modes would cost $1,800, $1,600 or $1,400 per year, respectively, versus the $1,250 annual payment.
The reason more frequent payment modes tend to cost more is that insurance companies need to offset the uncertainty and higher collection costs. Imagine you are the insurance provider. You are very likely to place added value on receiving a full year's worth of payments up front, because this means you have to worry about fewer late or missing payments in the future. Higher payments improve cash flow right away and make it easier to predict your future financial status. You can also use the extra money to make larger, earlier investments.
Think of modes of payments like the payments on a loan. In a loan scenario, borrowers who take a long time to pay back their principal usually end up paying more in interest. Similarly, the longer it takes a policyholder to pay the full cost of his annual life insurance coverage, the more it costs. Life insurance is not a debt and policyholders are not borrowers, but the relationships between time and cost of payment are comparable. Some insurance providers even offer an annual percentage rate (APR) calculator on their website to see how mode of premium payment influences the final cost.
Picking Your Mode of Premium
To secure the lowest overall cost for your life insurance, pick a less frequent mode of premium payment. Ignoring other considerations, the annual costs of less frequent payment modes are often substantially discounted, compared to more frequent modes.
Do not forget to consider two factors: opportunity costs and liquidity. Your liquidity is the amount of cash you have ready to make premium payments. If you only have $50 in the bank, it is probably unwise to choose a $1,250 annual premium payment option.
Even if you have the money for an annual payment, the opportunity cost of choosing a $1,250 annual payment over a $150 monthly payment is everything else you could have done with $1,100 in the short term. It may be possible to invest that money and earn more than the added cost of the monthly payment option.
Another consideration is that, if you terminate your policy early, many insurance providers do not refund portions of premiums already paid. Suppose you purchase life insurance and pay an annual premium on Jan. 10. Unfortunately, your insurable interests change midyear, and you decide to terminate your contract on July 10. Even though you only used 50% of your annual coverage, your insurance provider does not have to refund you the remaining 50%.