We’ve all been there . . . You go to the grocery store to get some milk and leave with a bag of chips and a slice of cake. You got distracted by all the stuff they put in your way before you reached the checkout. Hey, it happens to the best of us. And you know what? Shopping for life insurance can be just as distracting. (But sadly, not as tasty!)
Plenty of life insurance companies will swear up and down that whole life insurance is the way to go. What they won’t tell you is the stuff we’re about to. By the end, you’ll see that term life insurance is always the best option.
What Is Whole Life Insurance?
Whole life insurance is known as a type of “permanent” life insurance, meant to be in place for your entire life. In the beginning, you and the insurance company will decide your policy amount—what they call the “death benefit.” This is the sum that will be paid to your loved ones (or “beneficiaries”) when you die. Then you’re told how much your “premium” will be every month. The premium is what they call the cost of insurance. As long as you pay the premium, you’re covered.
How much life insurance do you need? Find out with our free calculator!
With whole life insurance, the premium is a locked in price. It can’t change. Also, a slice of that premium will go into what’s called the “cash value” part of your policy (more on that later). The longer your policy lasts, the more cash value it’s supposed to build up.
How Does Whole Life Insurance Work?
So you’ve signed up for some whole life insurance and know what your premium will be. That premium is split by the insurance company, with one chunk of it going into the cash value account, where it’s meant to make you some “cash value.” The other chunk covers the actual life insurance part of your policy.
Whole life insurance policies give you a “guaranteed” return on your investment(1), but this is possible because the ways they invest your money bring back very low returns on average. These low returns are, of course, easier to guarantee to the policy holder.
Let’s dig a little deeper into the process . . .
1. You pay your premium.
Every month, the insurance company puts a portion of your premium into your cash value account. The breakdown of how much is invested versus how much goes towards your policy varies over the years. In the earlier years, a larger percentage of your premiums are put towards the cash value, while in the later years, more of your premiums are going towards your policy since the cost of insurance will increase as you age.
2. Your cash value grows (very slowly) over time.
Your insurance company will give you an (unimpressive) interest rate on your cash value. If these rates were slices of cake, they’d be the almost-stale ones you see in the “get it before it expires" stand. So, like a savings account, your cash value is supposed to grow. And after you’ve built some up, you could choose to borrow against it, or leave it as it is (all come with downsides as we’ll explain soon).
3. You get to the “maturity age.”
Insurance companies have different ideas on what they define as “maturity age,” but most agree on 120 years old. So, if you live to be a 120, not only will you be on a very, very short list of supercentenarians, you can finally get a check for your cash value!
Or . . . (this is more likely):
4. You die before maturity, and your cash value disappears.
If you didn’t do anything with that cash value while you were alive, guess what? The insurance company keeps it! Your family gets the death benefit, while the insurance company nabs your cash value account. (This is one of the worst things about cash value life insurance, and why we will tell you to steer clear of it.)
How Can I Use My Whole Life Insurance Cash Value?
Most people don’t wait until “maturity” to take out their cash value. It can be tapped into any time you like. But be warned. This isn’t like getting a paycheck. Most whole life policies will let you borrow against it or cancel (surrender) the policy and claim whatever cash value you made. Let’s look at the options . . .
Taking out a loan against the cash value.
If you’ve built up some cash value, you can take out a loan against your policy. Like any loan, you’ll have to pay an interest rate, even to borrow against your own money. How crazy is that? And it gets worse—if you don’t pay back the money you borrow, your insurance company will deduct that amount from your death benefit.
You can surrender your policy.
You can also tap into the cash value of a whole life policy through a “cash surrender” or “cancelation.” You tell the insurance company that you want to cash out your whole life policy, and they send you a percentage of the policy’s cash value. How much you get depends on your particular policy, the fees the insurance company charges, and how long you’ve paid into it.
By now, you can see that no matter how you decide to tap into the cash value of a whole life policy, it will never work out in your favor in the long run! Your cash value will lose a lot of its weight, because you’ve invested less over the years, or you’ll have to settle for less than the full value of the policy you’ve been paying for. Either way, it’s not a good choice.
How Is Whole Life Different From Other Types of Permanent Life Insurance?
Like whole life insurance, universal and variable life are both “permanent” life insurances (meant to be in place for the long term) and they both build cash value. But they’re different in the way this cash value builds up. If whole life insurance was that almost-stale, ready-to-eat slice of cake, universal would be cake mix in a box (which, let’s face it, never tastes as good as you’d hoped).
How does universal life build cash value?
When you have whole life insurance, you have a fixed premium over the life of the policy. If those premiums are not kept up with, your policy may “lapse”.
Universal life insurance is meant to be more flexible by allowing you, the policy holder, to choose how much premium you pay within a certain range. The minimum amount is determined by the cost of insurance, which includes your death benefit and administrative fees.
Anything you pay over this is added to your cash value, which is guaranteed to grow according to a minimum annual interest rate set by the insurance company (though it can grow faster depending on market performance).
Many people choose to pay the maximum premium possible, which is set by the IRS, in the early years in order to build a larger cash value, and then use that cash to cover premiums later in life. But this is a risky move since the cost of insurance will increase the older you get! Question is, will you have enough cash value to cover it
What about variable life?
Variable life is a type of universal life insurance that provides an added layer of control—and confusion and risk. Unlike universal life and whole life, both of which have a fixed rate of return, variable life allows you to decide how your cash value is invested. You could put the cash value in investments such as the stocks and bonds market that offer a higher rate of return than whole life policies, but that choice comes with increased risks of losing it all! That’s the thing about variable life insurance—you make the call, and it’s a risky one if you’re not continuously keeping an eye on your investments.
Term Life vs Whole Life: Which Is the Better Choice?
Term life insurance is different to whole life, because it’s just life insurance and designed to last for a set number of years. We recommend a term of 15–20 years. There isn’t a cash value element with term life. This means the premiums are a lot cheaper than whole life policies. Let’s see why whole life insurance isn’t a great idea when you compare it to term life . . .
1. You’ll pay a higher premium.
And when we say higher premiums, we mean outrageously high. You’ll pay 10 to 15 times more a year for whole life than term life insurance. And why? For a “cash value” account that has a low interest rate? No thanks!
2. You can invest smarter.
People buy whole life because they think they’re killing two birds with one stone. They get life insurance and an investment. When you really think about it, using your insurance as an investment makes no sense—especially when there are better investment options out there. You can easily—easily—get more for your money by learning how to invest properly.
3. Insurance companies make more money on whole life insurance.
Who really benefits from whole life insurance? The insurance companies and agents who sell it. They make a whole lot more money on whole life policies than they do term, so which one do you think they push more? Don’t fall for it!
Let’s pretend we have a friend named Jack. He’s 30, active and in good health. He makes $40,000 a year and wants some life insurance. So what are his options?
Jack's Life Insurance Options
Whole life policy
20-year term life policy
Jack’s death benefit amount*(we recommend having life insurance coverage equal to 10 times your income)
What’s Jack’s monthly premium?
$18 (and Jack invests $82 a month into a Roth IRA or mutual fund)
Average made in investments after 20 years (by age 50)
$61,994 (assuming a 10% return)
Average made in investments (by age 70)
Look how much more Jack would have to pay in premiums for whole life! And because of the really low(1) levels of return with a whole life policy, his cash value won’t amount to much at all—compared with what he could make by taking control of his investments outside of his life insurance.
Jack would be way better off choosing a term life policy and building a generous retirement with the $82 per month he would’ve otherwise committed to an overrated whole life premium.
Your Best Option for Life Insurance
Remember what Dave says about life insurance: “Its only job is to replace your income when you die.” Get a term life insurance policy for 15–20 years in length, make sure the coverage is 10–12 times your income, and you’ll be set. Life insurance isn’t supposed to be permanent.
You might be attracted to types of cash value life insurance like whole life. We understand—you’re thinking about preparing a decent retirement fund. But by smart investing (setting aside 15% of your household income and putting it into a good mutual fund or Roth IRA) you’ll be in a much stronger position when it comes to retirement. Whole Life insurance—and the lousy way it builds up cash—just doesn’t compare to investing your money independently. Don’t leave investing to the insurance company!
To learn more about choosing the right life insurance for you and your family, talk to a qualified life insurance professional. Our trusted friends at Zander Insurance have been helping people find the best policy to protect their family for more than 50 years. Or if you want to do a quick check in on all of your coverage, take our 5-Minute Coverage Checkup to see if you have the right policies in place.