Life Insurance
Making sure that you and your loved ones are covered financially in case of emergency is one of the biggest parts of your financial well-being and should be a top priority when getting started on your financial journey. Insurance is a major part of this. Homeowners insurance, vehicle insurance, health insurance, and life insurance are a few examples of the different types of insurance most of us have needs for.
Certain insurances like homeowners and vehicle insurance are pretty straightforward and easy to understand. You insure the amount you’d need in order to replace the item if something were to happen to it. If you drive a $30,000 car your goal is likely to be able to replace that car with as little money out of pocket as possible in the event that car was no longer drivable.
When it comes to life insurance, it’s not always that easy. There are a couple different types of life insurance, and you should be cautious about which type you choose.
The two types of life insurance you are most likely to hear about are Term life insurance and Whole or Universal life insurance.
Term Life Insurance
Term life insurance works much like your vehicle insurance would. You select an amount of coverage and a term you want that coverage for and pay a premium to have that insurance available. Term insurance is typically inexpensive, especially if you are young and healthy.
If you have a $500,000 term life policy and were to unexpectedly pass away during the term of the policy, your family would get that $500,000 to cover their living needs in your absence. If you outlive the policy (which is likely) then you will have paid a relatively small premium for the peace of mind that your family would be covered if needed, similar to other insurances.
Whole Life Insurance
Whole life insurance is sort of a combination of insurance and investing. You pay a much higher premium, but the insurance does not expire unless you stop paying the premium – the policy is in place for your whole life. These policies usually have a “cash value” associated with them, which you would be able to access though there may be a fee associated. These policies may seem attractive because they are permanent and hold a cash value, but most of the time you would be getting a very low rate of return on your investment.
For most people, keeping insurance and investing separate will make the most sense. You don’t pay vehicle insurance and then become upset when you don’t use it. The same goes for term life insurance.
A good rule of thumb is to have about 10x your annual expenses in life insurance if you have dependents. If you don’t have dependents, there’s no one who would be counting on your support if you were to pass away, so you likely don’t have a need for life insurance at all.
Let’s look at a few examples:
Ex. 1
Policy type: Term
Term: 20 yrs
Coverage Amount: $500,000
Scenario: outlive the policy
Amount paid into policy: $6,240 – this is over a 20 yr period at $26/mo (the average I found for my age with a quick google search; I recommend doing a quick search of your own to compare numbers)
Rate of return: 0%
Cash value: $0
Ex. 2
Policy type: Whole
Period: 20 yrs
Coverage Amount: $500,000
Scenario: cash out the policy after 20 years (note: there may be a fee associated with cashing out your policy)
Amount paid into policy: $126,240 – this is over a 20 yr period at $526/mo (the average I found for my age with a quick google search; I recommend doing a quick search of your own to compare numbers)
Rate of return: 3.5% (this is a very generous rate of return, you are likely to see a much lower rate of return on a whole life policy)
Cash value: $182,453 (minus any fees associated with cashing out the policy)
Clearly with the whole life policy you have a higher cash value and rate of return, but what if you were to take the term policy but separately invest the extra you would pay for the whole life policy in index funds?
Ex. 3
Policy type: Term
Term: 20 yrs
Coverage Amount: $500,000
Scenario: outlive the policy
Amount paid into policy: $6,240 (same as term example above)
Additional invested in index funds: $120,000 – this is $500/mo (the difference between the whole life and term life policies above) over a 20 yr period
Rate of return: 10% (average for history of stock market)
Cash value: $379,684
Separating insurance and investing is the better option. Whole life or universal life insurance may make sense for some wealthy people as an ultra-conservative investment vehicle. If you’re wondering if that’s you, it’s probably not. Term life insurance makes the most sense for most people. If you have dependents and don’t have term life insurance in place, get it immediately – your family needs it.