by Nancy Osborne, COO of ERATE®
Of course no one wants to think about it but if you have dependents who rely upon you and your income to cover their living expenses, then you likely need a life insurance policy. With this type of insurance, your premiums are based on your age, your general health as well as how much your insurance company is able to earn from investing the collective premium payments it receives. There is a basic formula for determining the amount life insurance coverage you need: when a primary wage earner is lost, a family will typically require 75% of that wage earners after tax income in order to keep the same living standard as when the wage earner was living (60% of after tax income would be the bare minimum needed to meet essential living expenses). Life insurance falls into three basic categories: term, whole and universal. Term insurance is frequently referred to as temporary coverage because it provides benefits only at the time of death. Whole and universal life are considered permanent coverage as they provide both death and living benefits and have a cash value aspect to the policy.
Term life can be a cost-effective policy for those who have an insurance coverage need for a defined period of time. You may be required to complete a physical exam before your policy commences and the premium is based on the life expectancy of the insured as well as costs incurred by the insurance company. Premiums may be paid quarterly, semi-annually or annually. Term insurance offers the most coverage for the lowest cost and is the most economical given the time constraint of the policy. Term policies are available for various lengths of time and they expire either when you cease paying the premiums or at the end of your coverage period. If the policy holder dies outside of the term, a death benefit will not be paid to the beneficiaries. A term policy will pay the beneficiaries of your policy only if you were to die within the coverage period however if you do not, the policy has no tangible value beyond that of the peace of mind it will provide you knowing that you are covered. So while this policy is substantially less expensive than other types of policies, it offers only pure death protection for a defined period without any savings aspect to the policy or in the premiums you pay.
Whole life insures you for life and while the premiums are initially higher than that of term or universal policies, whole life policies come with certain guarantees. Essentially the premiums you pay on a monthly, quarterly or annual basis remain the same. The premiums required are higher than that of term insurance but the coverage is effective your whole life. This is a critical difference from term coverage in that the death benefit is guaranteed as long as long as the policy is in force and the premiums are paid. Whole life combines the insurance component of a term policy along with a savings-type account. This is the reason the savings account is attached to the insurance policy for as this account grows, the policyholder becomes essentially “self-insured” through his or her own account. The key benefit of whole life policies includes: guaranteed premiums along with lifetime protection, if protection is needed for 10+ years, this type of policy can be cost effective. The drawbacks of whole life are the higher, inflexible premiums and the fact that you require longevity in this policy to make it pay off; that is you need to maintain it for 10 or more years.
This type of policy is thought of as one that simulates a policy of term life insurance and then invests the difference. The insurance company deducts certain expenses, as well as the actual amount of insurance protection, from the cost of the premiums paid and the remaining balance of the premiums then earns interest in a way similar to that of a savings account. The advantage of this type of policy is that the savings element of the account earns tax-deferred interest. Premiums can also be extremely flexible and you may be able to avoid making payments if the cash value of the policy is sufficient enough to cover the insurance protection provided by the policy. In addition, you may have the option of adjusting the death benefit according to your needs. But the drawback of this type of policy is that at times (and depending upon what the savings component of your account earns) you may need to make additional payments to keep the insurance contract current and in effect. In addition, the savings options offered to you as part of the policy may not always be the most competitive available.
This type of policy is similar to that of universal life in many ways because it combines both the protection of a term policy as well as having a cash value to the account, but rather than earning interest, the cash portion of the account may be invested in a variety of options from which you can choose (i.e. mutual funds and securities). Therefore the primary difference from that of universal life is that you are able to choose the investment vehicle yourself and assume the associated risk. So while you are able to enjoy the benefit of professionally managed, tax-deferred growth in your account, exposure to risk could put both your insurance as well as the underlying investment at risk. Thus this type of policy may not offer you the most competitive insurance or be the most cost effective or flexible investment.
In conclusion, term life can be very cost-effective for people with a pure life insurance need for a defined period of time. Both whole and universal life policies may be right for those who want to combine both an insurance need with a savings or investment need as well as those who have a permanent or life long need for coverage. In the final analysis, term insurance may be the best and simplest deal for all but the affluent, for if you look at a whole or universal policy as a retirement savings account or as your primary means of accumulating growth on a tax-deferred basis, you are likely to regret it.
Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.
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