Does the Cash Value of Whole Life Make it Better than Term?
On the surface, this would make sense. A whole life policy does in fact build up cash value over time, whereas a term policy is “use it or lose it”, meaning if you don’t die before the term is up, you get nothing out of it. Even though building up cash may sound better than not, it is important to understand how a whole life policy actually works.
Whole Life Insurance
Whole life insurance is designed to pay out a predetermined benefit upon death, while also building cash value via an investment component. There are various types of whole life policies, from universal, variable, and traditional, but they are all the same aside from how the cash value portion is invested. The problem with whole life is that not only are you paying for the coverage premium, but you’re also paying into the cash value portion. This makes the premiums much higher than term insurance.
Rate of Return and Fees
A typical whole life policy will have an internal rate of return, which is how much interest your cash value will earn after fees and expenses are deducted. Unfortunately, most whole life policies are like mutual funds with high expense ratios; after you factor in the annual fees, the actual return is minimal. In some cases you may only earn a couple percentage points. You’ll also want to be aware of penalties or fees incurred when canceling a policy, as these can be quite steep.
Why Term is Better
Even though you may never receive a payout from your term policy, remember, you are just buying protection for your loved ones. Insurance always seems like a waste when you never see the rewards, but if you don’t have any coverage and the unfortunate does happen, the results can be devastating. So, what seems like a better deal; paying a lower premium that builds no cash value, or paying a much higher premium to earn 3% on only a fraction of the amount?
For working adults, term is almost always the way to go. Typically you purchase insurance once you get married and/or have children. Once the kids are out of the house and you’re beginning to approach retirement, your need for life insurance drops rapidly. This is why a 30 year old would be perfectly fine with a 30 year term policy.
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Does Whole Life Have Any Use?
Whole life policies do have their place, just typically not for working adults. These policies can provide significant wealth transfer and estate planning benefits, but are more than likely far too costly for someone in their 30s or 40s. You really need to be careful when dealing with an insurance salesman as they can do a pretty good job at making whole life sound like an investment. Granted, there is an investment component, but you can save money by buying a term policy and earn far more by investing the difference elsewhere.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.