Many people wonder what the difference between Term and Permanent
life insurance is and if they should own one or the other. The answers to these questions are really quite simple.
Term Life Insurance is a policy that lasts for a specified period or term. Typically the terms run 10, 15, 20, 25 or 30 years. Term policies are less expensive than permanent policies because you are only paying for the death benefit for a known period of years. In addition the younger the insured is at the time of purchase, the lower the cost of the insurance. There is no cash built up in a term life policy and when the term ends the policy expires with no death benefit or continuation of coverage.
Term life policies are an excellent way to provide inexpensive coverage for a mortgage, a debt or child's education. Once the debt is gone or the child is off on their own, there is no more reason for the insurance.
Permanent life insurance policies, on the other hand, can last for the life of the insured. The most common type of Permanent life insurance is a Whole Life Policy, but there are also other types such as Universal Life and Variable Life policies. Permanent life policies are more expensive coverage than term life. In addition permanent life insurance generally builds a Cash Value which can be borrowed against, used to fund retirement or to even pay premiums in the later years of the policy.
Permanent Life policies provide lifelong coverage for a spouse, burial expenses, to pay taxes on an estate and many other situations.
The best advice to the question of which type of policy to own is to buy a permanent policy when you are you young so that you can lock in lower premiums; and supplement with term policies for specific needs.
Accumulation phase - The period of time prior to annuitization.
Annuitant - A person who receives benefit payments from an annuity.
Annuitize - A method of receiving annuity benefits through a series of income payments for life or some other defined period of time.
Annuity - A contract with a life insurance company which guarantees an income for life or some other defined period in exchange for premiums you pay.
Back-end load - Company expenses that are charged at the time benefits begin.
Beneficiary - When provided in a contract, the person who receives benefit payments if the annuitant dies.
Contractholder - A person who pays premiums for an annuity. Often the same person as the annuitant.
Death benefit - A provision in certain annuity contracts that pays the beneficiary when the annuitant dies before the payout phase begins.
Deferred annuity - A contract that begins the payout phase at some future date.
Equity-indexed annuity - A contract that combines a guaranteed minimum interest rate with earnings linked to the performance of an external stock or bond index.
Fixed rate annuity - A contract that specifies your funds will earn a specified interest rate and guarantees a return on your premium.
Flexible premium annuity - A contract in which the amount of each premium payment you make can vary.
Front-end load - Company expenses that are charged at the beginning of a premium payment period.
Free look - A period specified in the contract (such as 10 days) during which you can decide whether to keep an annuity or return it for a full refund of your premium. Your free-look period is 20 days when you buy an annuity contract to replace one you already had.
Guaranteed interest rate - A minimum rate of interest specified in a fixed annuity. The actual rate the insurance company credits your contract at any given time may be higher but can never be lower.
Immediate annuity - A contract that begins the payout phase within one year after you pay the single premium.
Level premium annuity - A contract in which the amount of each premium payment you make stays the same.
Loan provision - A feature in certain annuity contracts that allows you to borrow up to a specified percentage of the value. Contract loans are usually subject to taxes.
Morality Tables - Statistics that project ones life expectancy based on many variables.
Payout phase (also called the annuity phase) - The period of time when benefit payments are being made to the annuitant.
Premium - The money you pay to fund an annuity contract.
Refund Annuity - Refunds part or all of the premiums paid if the insured dies before the start of the liquidation period.
Surrender charge - A fee the insurance company will charge you if you cash in (surrender) an annuity before the payout phase begins, or if you make a withdrawal larger than specified in the contract.
Variable annuity - Traditionally, a contract with no minimum guarantee (some newer products do include guarantees). Because the benefit amount depends on the insurance company's investment gains or losses, you share some part of the investment risk with the insurer.
Withdrawal privilege - A provision in many annuity contracts that allows you to withdraw an amount less than the surrender value, without paying a surrender charge. Any withdrawal may be subject to taxes and penalties.
The best way to make an informed decision about buying life insurance is to become familiar with the basics. There are three life insurance basics that all consumers should consider:
- Start by considering how many people are financially dependent on you, what their major expenses are likely to be and whether you're likely to leave them with substantial debts or taxes to pay on your estate. Life insurance can help on all of those fronts.
- Evaluate the two main types of life insurance: term life and permanent life. As its name implies, term life insurance pays a death benefit if you pass away within a specified time period. Permanent life insurance lasts your lifetime and also has the ability to build up cash value during the term of the policy.
- Understand the major factors that can affect life insurance premiums. Some are uncontrollable, like the age at which one purchases a policy or a serious pre-existing medical condition, like cancer or heart disease. Other factors are much more dependent on an individual's behavior, like poor health habits (e.g., smoking and excessive drinking), driving record (e.g., accidents and Driving While Intoxicated citations), engaging in dangerous hobbies (e.g., sky diving, car racing or rock climbing) and even where one lives, since mortality rates in a geographic region may be used by life insurance companies to help establish premiums.
An important feature of life insurance is that there is no federal income tax on proceeds paid to beneficiaries.
How much life insurance do I need?
Before buying life insurance, you should assemble personal financial information and review your family's needs. Factors to consider include:
- Any immediate needs at the time of death, such as final illness expenses, burial costs and estate taxes;
- Funds for a readjustment period, to finance a move or to provide time for family members to find a job; and
- Ongoing financial needs, such as monthly bills and expenses, day care costs, college tuition or retirement.
One rule of thumb is to buy life insurance that is equal to several times your annual gross income, to allow your family the ability to continue their lifestyle for several years without hardship.
If you need to stop paying premiums, you may be able to use the cash value to continue your current insurance protection for a specific period of time or to provide a lesser amount of protection to cover you for as long as you live. Usually, you may borrow from the insurance company, using the cash value in your life insurance as collateral. Unlike loans from most financial institutions, the loan is not dependent on credit checks or other restrictions. You ultimately must repay any loan with interest or your beneficiaries will receive a reduced death benefit.
What are the advantages and disadvantages of term and permanent insurance?
Term Insurance
Advantages
- Initially, premiums are generally lower, allowing you to buy larger amounts of insurance at a younger age when the need for protection often is greatest due to debt.
- Good for covering specific needs that will disappear in time, such as mortgages or car loans.
Disadvantages
- Premiums increase as you grow older.
- Coverage may terminate at the end of the term or may become too expensive to continue.
- Generally, the policy doesn't offer cash value or paid-up insurance.
Permanent Insurance
Advantages
- As long as the necessary premiums are paid, the policy will last your lifetime, or age 95 or 100, whichever is stated.
- Policy accumulates cash value that you can borrow against, or withdraw if needed.
- A provision or "rider" can be added to a policy that gives you the option to purchase additional insurance without taking a medical exam or having to furnish evidence or insurability.
- Premiums never change during the life of the policy.
Disadvantages
- Higher premiums than term insurance which may not be as affordable.
- It may be more costly than term insurance if you don't keep it long enough.
Permanent life insurance pays off in
the event of your death, but it operates differently than term life insurance.
You pay a premium that much larger
than the premium for term -- often five to 10 times the size -- but a portion
of that premium goes into a savings component known as the policy's "cash
value." That's why permanent insurance is sometimes referred to as "cash
value" insurance.
Initially, the cash value is very
low because much of the early premiums go to sales charges and the agent's
commission. Over time, however, the cash value can grow, depending on the
dividends or interest the insurer pays policyholders.
There are several different types of
permanent insurance or cash-value policies, but the most common are whole life
and universal life.
There's one other crucial difference between
permanent and term policies. As their name implies, permanent policies are
permanent. As long as you pay the premiums and keep the policy in force, you
can keep the policy your entire life (which accounts for the name "whole
life" policy).
Term Life Insurance or Permanent
Life Insurance: Which One Meets Your Needs?
Term life insurance is designed to help
people purchase the protection they need when they can't afford to purchase all
permanent life insurance or when they only need coverage for a specific period of
time. Term life insurance has a guaranteed death benefit but no cash value and
the premiums will increase at pre-determined intervals such as 1 year, 5 years,
10 years and 20 years.
It is also very often the product of
choice when protection needs may be high for a period of time, and then drop
back, such as when your family is growing. Term insurance can also be an
effective way to supplement permanent insurance during high-need years, such as
when family and other financial responsibilities are outpacing income.
In these situations, term coverage
allows you to obtain crucial death benefit protection without breaking your
budget. Also, if the coverage is convertible (the coverage can be
"converted" to a comparable cash value policy, without the need to
provide evidence of insurability), you can get the coverage you need today —
with the ability to obtain permanent coverage in the future. In this respect,
term insurance meets a valuable need.
The True Cost of Term Insurance
However, term insurance has its drawbacks. It certainly isn't right for all
people or under all circumstances. Among its weaknesses, be aware of the
following:
- You do have to "die to win." As
unpleasant as that sounds, it's true. Term life insurance provides a death
benefit only, for a specific period of time. When the term coverage
expires, so does your protection. Also, if you stop paying premiums, the
coverage ends. Period.
- Let's say that you own $500,000 of term insurance. You've
kept the coverage in force for ten years, and the policy expires at
midnight on December 31. If you die at 11:59 on New Year's Eve, your
beneficiary receives the full $500,000 in death benefit proceeds. However,
if you die at 12:01 on January 1, your beneficiary receives nothing
under the policy, since the contract has expired.
- Purchasing term insurance is often compared to renting
a house. When you rent, you get the full and immediate use of the house
and all that goes with it, but only for as long as you continue paying
rent. As soon as your lease expires, you must leave. Even if you rented
the house for 30 years, you have no "equity" or value that
belongs to you.
- There is the very real danger of becoming uninsurable
when the term coverage expires. While many term policies are convertible
to permanent coverage, others may not be. Most of all, even if the
coverage is convertible, there are time limits. If the policy is allowed
to expire, you may be required to reapply. If you are found to be
uninsurable at that time, you will be without coverage.
- Since premiums increase at each renewal, the long-term
cost of term can be burdensome. Many people buy term coverage when they're
in their 20s because it seems more affordable when compared to a cash
value life insurance policy with the same death benefit amount. By the
time they're in their 40s, the coverage seems a bit pricey, as the rate
goes up. In their 50s, the cost has generally outstripped the cost of
permanent coverage. Finally, in their 60s, if not sooner, they drop the
policy — not because they no longer need the protection, but because they
usually can't afford it. Meanwhile, the person who may have paid more for
that permanent policy in his or her 20s may still be paying the same
premium. That's why the term policy's conversion privilege is so
important. This valuable feature is usually available in the first few
years of the policy, and allows you to convert to permanent insurance
without submitting evidence of insurability. Converting to a permanent policy
lets you "lock in" a fixed and level premium, and your coverage
can never be canceled provided premiums are paid.
The Value of Permanent Life
Insurance
Cash value life insurance is often the best long-term solution for many people.
The reasons:
- Cash value life insurance provides life-long insurance
protection, provided premiums are paid. With few exceptions, once you have
been approved for the coverage, your policy cannot be canceled by the
carrier. Regardless of your health, the insurance will remain in force.
- Despite higher initial premiums, cash value life
insurance can actually be less expensive than term in the long run.
Most permanent policies are eligible for dividends, which are not
guaranteed, if and when they are declared by the insurance company. Many
companies offer the option to apply current and accumulated dividend
values towards payment of all or part of the premiums. If dividend values
are sufficient, out-of-pocket premium payments may end or be reduced after
several years, yet coverage can continue for life. So while premiums must
be paid under both the permanent and term insurance plans, long-term
out-of-pocket cost of permanent life insurance may be lower compared to
the total cost for a term policy.
- It can eliminate the problem of future insurability.
Cash value life insurance does not expire after a certain period of time.
Also, some policies contain guaranteed purchase options, which allow you
to buy additional coverage at specified times, regardless of your health.
- It builds cash value. This amount — part of
which is guaranteed under many policies — can be used in the future for
any purpose you wish. If you like, you can borrow cash value for a down
payment on a home, to help pay for your children's education or to provide
income for your retirement. (Note: Borrowing cash value from your policy
requires the payment of loan interest and will affect your total policy
values.) Plus, if you decide to stop paying premiums and surrender your
policy, the guaranteed policy values are yours.
Recommendation: When purchasing coverage — renewing or converting a term
policy — look at more than just the premium.