Two of the oldest varieties of life insurance, term and whole life, remain among the most popular types. Not that insurance companies haven't tried to make it more complicated to reach a broader range of customers. Shopping for life insurance may not be as fun as reading a spy novel, but they have this in common: The more deeply you delve, the more complex everything gets.
But getting back to basics, what’s the difference between term and whole life, and which one is better for your needs? We’ll break down the key features that distinguish these insurance mainstays.
- Term life is “pure” insurance, whereas whole life adds a cash value component that you can tap during your lifetime.
- Term coverage only protects you for a limited number of years, while whole life provides lifelong protection—if you can keep up with the premium payments.
- Whole life premiums can cost five to 15 times more than term policies with the same death benefit, so they may not be an option for budget-conscious consumers.
Term Life Insurance
Term life insurance is perhaps the easiest to understand, because it’s straightforward insurance, without the bells and whistles. The only reason to buy a term policy is because of the promise of a death benefit for your beneficiary should you pass away while it’s in force. As the name suggests, this stripped-down form of insurance is only good for a certain period of time, whether it’s five years, 20 years, or 30 years. After that, the policy simply expires.
Because of these two attributes—simplicity and finite duration—term policies also tend to be the cheapest, often by a wide margin. If all you seek from a life insurance policy is the ability to protect your family when you die, term is likely the best fit. While no two families are exactly the same, new parents sometimes purchase insurance that lasts just long enough for their kids to finish college or join the workforce full time.
According to the online brokerage Policygenius, the average 30-year-old male can get a 20-year term policy with a $500,000 death benefit for $28.73 a month. Because of her typically longer lifespan, the average 30-year-old woman can purchase the same policy for just $23.02.
A variety of factors will change those prices, of course. For example, a larger death benefit or longer length of coverage will certainly increase the premiums. Also, most policies require a medical exam, so any health complications could raise your rates above the norm as well.
Because term insurance eventually expires, you can find yourself having spent all that money for no purpose other than peace of mind. Also, you can’t use your investment in term insurance to build wealth or save on taxes.
Generally, term insurance has a much lower cost than other types of life insurance.
It is simpler to understand than “permanent” policies.
Protection is only available for the term of the policy.
It cannot be used as a wealth-building or tax-planning strategy.
Whole Life Insurance
Whole life is a form of permanent life insurance, which differs from term insurance in two key ways. For one, it never expires as long as you keep making your premium payments. It also provides some “cash value” in addition to the death benefit, which can be a source of funds for future needs.
Most whole life policies are “level premium,” meaning that you pay the same monthly rate for the duration of the policy. Those premiums are split in two ways. One part of your payment goes to the insurance component, while the other part helps build your cash value, which grows over time. Many providers offer a guaranteed interest rate (often 1% to 2% annually), although some companies sell “participating” policies, which pay unguaranteed dividends that can increase your total return.
Early on, the amount of the whole life premium is higher than the cost of the insurance itself. As you get older, though, that reverses, and the cost becomes less than that of a typical term policy for someone of your age. This is known as “front-loading” your policy. At a later date, you can borrow or make a withdrawal from your cash value amount, which grows on a tax-deferred basis, to pay for expenses such as your kid’s college tuition or repairs to your home. In that sense it’s a much more flexible financial tool than a term policy. Loans from your policy are tax free, although you’ll have to pay income tax on the investment gains from any withdrawals.
Unfortunately, the death benefit and cash value aren’t completely separate features. If you take a loan from your policy, your death benefit will go down by a corresponding amount if you don’t pay it back. If you take out a $50,000 loan, for instance, your beneficiaries will get $50,000 less, plus any interest due, if the loan is still outstanding.
The main disadvantage of whole life insurance is that it’s more expensive than a term policy—by quite a bit. Permanent policies cost on average between five and 15 times more than term coverage with the exact same death benefit. For a lot of consumers, the relatively high cost makes it hard to keep up with payments. A June 2016 report by the Wharton School at the University of Pennsylvania found that roughly 25% of permanent life policies lapse within the first three years.
Another potential drawback of whole life insurance is its complexity. With a term policy, for example, you can simply stop making payments if you no longer need the insurance or can no longer afford it. However, depending on your carrier, whole life policyholders may face a surrender charge of up to 10% of the cash value if they decide to walk away from their policy. Usually this charge reduces as the years go by, until it finally disappears.
With whole life insurance, you have the ability to borrow against the policy for future financial needs.
Loans, like death benefits, are generally tax free.
You can lock in your premiums for life.
Whole life insurance is much pricier than comparable term policies.
If you have to let the policy lapse within the first few years, you could face surrender charges.
Any outstanding loans will reduce your death benefit.
Choosing Your Coverage
So which type of coverage is best for your family? If term coverage is all you can afford, the answer is simple—basic protection is better than no protection at all.
The question is a little trickier for folks who can afford the substantially higher premiums that come with a whole life policy. If your goal is to save for retirement, many fee-based (that is, non-commission-earning) financial advisors recommend turning to 401(k)s and individual retirement accounts (IRAs) first. After maxing out those contributions, a cash value policy may be a better option for some people than a fully taxable investment account.
Some consumers have unique financial needs that whole life can help them manage more effectively. For example, parents with disabled children may also want to consider whole life insurance, as it lasts your entire lifetime. As long as you keep paying the premiums, you know your kids will receive the death benefit from your policy.
It can also be a valuable tool in succession planning for small businesses. As part of a buy and sell agreement, business partners will sometimes take out whole life insurance for each owner, so that the remaining partners can purchase the deceased’s equity stake in the event of their passing.
The Bottom Line
Whole life insurance certainly offers more financial flexibility with its cash value component. Nevertheless, because permanent policies are more complex and expensive, a lot of consumers follow the old axiom “Buy term and invest the rest.”