What Is Comparative Interest Rate Method?
The comparative interest rate method is a way to calculate the difference in cost between two different types of insurance policies. Specifically, the comparative interest rate method is used to illustrate the difference between the cost of a whole-life policy and a decreasing-term policy with a side fund.
The comparative interest rate method offers potential insurers and their agents the ability to make comparisons in costs and benefits across the two different types of products. Since interest amounts change, the value of the products can also change over time, as can an individual’s needs.
The Basics: Whole-Life Policies Versus Decreasing-Term Policies
A whole-life policy accumulates value by an insurer making regularly scheduled premium payments on the policy. The policy accumulates value over time that can be borrowed against, depending on the terms and conditions of the individual policy. Once the insured passes away, the beneficiaries can collect the balance of the policy in a lump sum death benefit, or request that it be paid out in dividends. These types of policies are also sometimes referred to as permanent or traditional life insurance policies.
A decreasing-term policy with a side fund does not accumulate value as the insured pays into it. Instead, the policy is only active while payments are being made, and can be terminated with no payout at any time. These are generally used to cover the debt on large assets, such as a mortgage, for a smaller monthly premium than a whole-life policy. They are purchased by term, as the name implies.
Real World Example of the Comparative Interest Rate Method
As a hypothetical example, take a 30-year-old non-smoker in good health who wants $150,000 in coverage for thirty years—he could expect to pay under $100 a month in premiums for a term life insurance policy, but this policy would only cover him if his death occurred during the 30-year-term of the policy (up to age 60).
Once the term is up, if the insured wanted to remain covered, the insured would need to purchase a new policy to cover a new term. If the insured carried that 30-year term policy from the age of 30, until they were 60, they would be faced with buying a new term policy at the age of 60 which could open them up to greatly increased premiums and restrictions.
Moreover, it is more probable that his health situation would be more precarious at 60 years of age than 30. If he were to again purchase another 30-year term policy at 90 years old, the premiums would be even higher, and it is very likely that no insurance company would even offer him coverage at that age.
In the case of a whole-life policy, the cost to the insured would be quite a bit larger than that $100 in monthly premiums at the age of 30—perhaps as much as $1,000 or more per month. But he would be covered his entire life as long as he continued making the monthly premium payment.
The premiums on whole-life policies are often fixed and so do not change over the life of the policy. The insured could presumably expect to pay the same monthly premium they did at age 30 at age 75. Whole-life policies also have the benefit of accumulating cash value that can be withdrawn or borrowed from over time, while a term policy has no such value associated with it.