Whole Life Insurance vs. Term Life Insurance

A friend of mine recently asked me the difference between whole life insurance and term life insurance. At that point I realized that I’ve largely neglected discussing insurance on Hacking The Bank, so I figured I might as well start now. So… Term Life Insurance vs. Whole Life Insurance: Which one is better for you?

First, I think it’s important to think about the purpose of insurance in general. Insurance is created to protect you against outcomes with low odds, and high expense. These situations, though unlikely, would be very damaging if they happened to you. Examples of these include being diagnosed with cancer or causing a five-car pileup. Without insurance, these two circumstances could easily bankrupt someone. The odds of each isn’t very high. Because of this, people band together to insure each other. An insurance company collects money from a large group of people to offer assistance to the small number of people who are affected.

Now, with that general definition of insurance, I think we can continue with our discussion about life insurance. When it comes to life insurance, we are insuring against the unfortunate outcome of death. However, as we know, death and taxes are the only guarantees in life. So we aren’t looking to insure against death in general. More specifically, life insurance exists to insure against death when our dependents cannot afford for us to die. So when is this? Well, let’s look at some examples.

Let’s pretend that I’m a 19 year-old student in college, with no girlfriend, kids, or other dependents. I am not making any money. At this point, I have a high future earnings potential once I graduate, but at this time I have nobody depending on my income. There isn’t anybody who will be significantly financially impacted by my death, and thus life insurance is not really necessary.

Now, let’s fast forward five years. Let’s say I have a good paying job, a wife, and a kid on the way. I have high future income potential and I have a wife, as well as a future child, who depend heavily on my income. This is the time when I need life insurance most. Others are depending on my income, and if I were to die, they would need that insurance money.

Now, let’s fast forward 25 years from that moment. I’m now 50, I have a comfortable retirement, and my kid has graduated college and now has a respectable job of his own. With a lower future income potential, and nobody really depending on my future income (I said that retirement savings was comfortable), life insurance is once again unnecessarily.

Now, we’ve established that there is a specific time frame for when life insurance is needed, and when it is unnecessary. Within this context, lets take a look at Whole Life Insurance vs. Term Life Insurance.

Whole Life Insurance
Whole life insurance acts exactly as you might expect; it remains in effect for the entire life of the insured person. It was created as a product to sell to those who were upset with the possibility that they might pay premiums for 20 or 30 years and never receive any benefit. Whole life essentially collects premiums, which are invested on your behalf, to pay out upon your future death.

Term Life Insurance
Term life insurance is insurance that covers a specific time period (term). Common policies are twenty to thirty years. Under these policies you will pay a much lower premium than whole life insurance because you will simply be purchasing insurance for the time period needed and there is no investment portion attached.

Term life insurance is going to cost you much less in premiums and will still protect you for the term needed. Whole life insurance ends up being an investment vehicle that provides mediocre returns and lines the pockets of insurance companies and insurance brokers.

If any “financial planner” tries to sell you on whole life, universal life, or any similar insurance, you shoulder consider asking them two things:
1. What commission will they earn if you purchase the policy?
2. Is this financial planner serving you as a fiduciary?
I can pretty much guarantee that this person is not acting as a fiduciary (in your best interest) and that they will earn a significant commission (about 50% of what you pay in the first year), as well as a recurring commission for the lifetime of the policy.

In most cases, term life insurance is going to make the most sense. However, as with all things personal finance, the “best” decision for you is going to depend on the facts of your current situation and goals. It would be best to do further research and potentially consult with a fee-based independent financial adviser.