Deciding the Best Life Insurance Policy
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To decide which kind of life insurance policy is best for you, the first thing to understand is the difference between the two major types: term insurance and cash-value insurance.
Term insurance is pure insurance: your premium payments go toward the guaranteed death benefit for your survivors. Well, almost exclusively. A portion also pays the agent’s commission and the insurance company’s overhead and profit. The term policy is good –in insurance terms “stays in force” –as long as you keep paying the premiums. When you stop paying, you’re no longer insured.
Cash-value insurance, on the other hand, is a hybrid. It’s life insurance combined with a savings fund. Part of the premium you pay goes toward the death benefit, the commission, and so forth, just as with term insurance. But a large piece of your premium goes into a tax-deferred investment fund. The balance you build up in this investment fund is known as the policy’s cash value. The cash value has a guaranteed interest rate, typically 4% to 5%; but the policy is likely to earn more than that for you. Depending on the policy, you can eventually borrow against your cash value or even withdraw it. Insurance agents sometimes like to call cash-value coverage “permanent insurance”.
So which kind of insurance is best: term of cash value? For most people, term is the clear winner. If you’re young or your money is tight, opting for a cash-value policy is downright foolish. That’s because for the same death benefit, term insurance is far less expensive, especially in the early years. And the commissions are far less steep (commissions on cash-value policies generally run five to 10 times higher than those on term policies.) If you’re 35 and want to buy $500,000 worth of life insurance, your annual term premiums will run about $850 to $1,500. A cash-value policy might cost you three times as much in that first year.
The most common type of term insurance is called annual renewable term. Its premium rises each year as you age. Male nonsmokers can buy $250,000 worth for as little as $275 a year at age 30, $325 at age 40, and $875 at age 50. Women pay less: smokers pay much more. You generally cannot renew the policy after age 70, at which point you probably won’t need life insurance anymore anyway. If you go with an annual renewable term policy, make sure the contract guarantees that you’ll be able to keep it regardless of changes in your health. Another kind of term: level-premium term, which has premiums that remain constant for a period of years, then spike up.
Price hikes for annual renewable term are not as scary as they may sound. While the premium rate keeps rising, the amount of coverage the typical family needs will likely level off and then decline. That’s because as your children grow up and your savings and investments accumulate, you typically need to own less insurance, not more. And cutting back on the death benefit amount means lowering the premiums.
If you’re shopping for a term policy, don’t be taken in by one just because it has the cheapest first year premium. Instead, make sure the agent shows you its projected annul cost five, 10, and 20 years into the contract (through what’s known as a policy illustration) and the maximum premium charge in each case. A policy with the lowest initial premium may cost more as the policy ages than a similar policy with a higher initial charge. Your agent may recommend a level-term policy with set premiums for an extended period, such as 10 years. Since the premium is basically an average of the cost for the entire period, you’ll pay more in the early years of the level policy than with a traditional annual renewable term. That’s fine, but go for level term only if you expect to keep the coverage for the entire period.
The typical cash-value policy carries a much higher premium than a term policy because that premium must cover two things: insurance plus savings. That high premium ordinarily stays the same each year. But unlike term, cash-value insurance can be kept until you’re at least 95. If you decide to purchase a cash-value policy, be sure you’ll hang on to it for at least 10 years. Otherwise the policy’s fees and agent commissions will eat up far too much of your cash-value fund.
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2 Responses to “Deciding the Best Life Insurance Policy”
I have to disagree with you that annually renewable term is the most common. In fact, guarantee level term is the most common type of term sold. ART doesn’t make sense in this day and age when you can lock in low annual rates for 10, 20 or even 30 years.
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Byron Udell (Who am I?) on Aug 25, 2008