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If anyone depends on you and your income to survive, you should probably have life insurance. Life insurance usually offers a big payout for your loved ones, called beneficiaries, in the worst-case scenario that you die.
Protecting those who rely on you is an important step for most families. But not all life insurance is created equal. Here are five important reasons term life insurance makes more sense than permanent life insurance for most households.
1. Term life insurance is much cheaper
The first reason term life insurance is better than whole life or universal life is the monthly or annual cost, called a premium. While rates can vary dramatically depending on the coverage level, type of policy, and insurance company, whole life policies typically cost around five to 15 times more than term life insurance.
That means someone who could find a great term life policy for $50 per month might have to pay anywhere from $250 to $750 per month for a comparable permanent life insurance policy.
Many families could come up with an extra $50 per month, or sometimes less, for term life insurance. But hundreds or even more than $1,000 per month for whole or universal life could be cost-prohibitive.
2. Permanent life insurance tries to combine insurance and investments
Life insurance is a very good idea for many households. Similarly, investing for the future is almost always the right thing to do for any adult. While these are both good strategies for your finances, combining the two doesn't always make sense.
Term life insurance offers excellent coverage at a very low cost. The highly specialized product does just one thing and does it very well. The same is generally true of high-yield savings accounts and investment accounts.
Permanent life insurance generally includes a life insurance component and a savings or investment component. The thing is, while it can create a good savings habit that leads to a growing cash value, you would often have more if you just set up an automatic savings plan in a savings account rather than using life insurance as a way to save.
3. You have a potentially low rate of return with permanent life insurance
When you have a savings account or CD, the interest rate may not be spectacular, but you'll always know what you're getting. As you take on more risk with fixed income and stock investments, you may earn even more. Historical averages for the S&P 500 come out to around 10% per year over a period of time.
My friend Robert over at The College Investor looked at an example where one of his readers had a whole life insurance policy that he signed up for at age 33 with a $1,982.72 monthly premium. After 79 months of payments, his cash value results in a loss of 40%. That's huge!
While many policies are going to give a much better result, this example shows just how bad some permanent life insurance policies can be. Even a modest savings account interest rate is better than a negative return from life insurance.
4. Accessing the cash value from your life insurance can be confusing
Savings accounts are pretty simple. Term life insurance is fairly straightforward. As long as you understand what you're doing, investment accounts don't hold many surprises. Whole and universal life insurance, however, are often very complex and confusing products.
The cash value component of permanent life insurance generally grows over time at a guaranteed rate as long as you keep making payments. There may also be opportunities to reinvest income generated by the policy or use other features to grow your cash balance even faster if you want to.
When it comes to accessing the cash value, you often have the option to take a loan from the cash value, surrender (close) your policy and take the full cash value, or withdraw a portion of the cash value. Each has pros and cons and different long-term results. But none are ideal compared to withdrawing from savings or a taxable brokerage account in most cases.
5. Dividends are not guaranteed
One positive feature that some permanent life insurance policies offer is an ability to earn dividends. When your insurance company makes a big profit, they may share a portion of that profit with policyholders through a cash dividend.
This is similar to an investment dividend from a stock. You can often choose to keep the cash or reinvest it into your account. But while this is a good thing, don't let a small dividend distract you from bigger returns in your long-term investment accounts.
Worst of all, those dividends are not guaranteed. If the insurer experiences a bad year, you could get nothing.
Term life is almost always the best choice for life insurance
Whole or universal life insurance do make sense for some households, particularly those with high net worths that are looking for opportunities to manage taxes and inheritances.
But for the typical American household, term life insurance is almost always the better choice. Lower costs for higher levels of coverage are a win-win for your budget and your loved ones.
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