Term Life Insurance vs Whole Life Insurance: Which is Best?

As the name implies, term life insurance covers you for a set period. Typical terms are 10, 15 20 or 30 year periods. During that time, you will pay monthly premiums for a specified amount of coverage, aka death benefit. If you die during that term, the life insurance company will pay out your death benefit to your beneficiary(s).

If you do not die during that term, your death benefit will not be paid out and your coverage will end. You can buy another term policy if you desire or convert your term policy into a permanent policy if available. For example, let's say that you have young children who depend on you and decide to buy a 20 year term policy for $1 million to protect them.

God forbid you die in the next 20 years, your policy would pay out $1 million to your beneficiary(s) which might be your spouse or your children depending how you set up the policy. The death benefit passes tax free to your beneficiary(s) meaning they would not owe any taxes on the $1 million. If you are alive after 20 years, your coverage would end.

Outside of getting life insurance through your employer, term life insurance is the most affordable way to get coverage. Most term life insurance policies do not pay out which means insurance companies are able to charge lower premiums for coverage.

Whole life insurance is a type of permanent life insurance. This means you get coverage as long as you live and, the death benefit of your policy will be paid out to your beneficiary(s) whenever you die. This is different than term life insurance which only covers you for a set period of time such as 10, 15 or 20 years.

Your death benefit is the amount of money that your policy will pay out when you die and your beneficiary(s) are the person(s) who will receive this money when you die. For example, let's say that you bought a whole life policy with a death benefit of $250,000 and made your spouse your beneficiary.

When you pass away, your death benefit of $250,000 would be paid out to your spouse. This death benefit would pass tax free to your beneficiary meaning they would not owe taxes on the $250,000. Whole life insurance also has a few other features.

First, whole life insurance has level premiums. This means that your monthly cost (premium) to pay for the policy remains the same if you maintain the policy. If you are young and healthy, you can lock in a reasonable rate on a whole life insurance policy that will remain the same.

Secondly, whole life insurance offers a cash value component. When you pay your monthly premium to your insurance company each month, that money goes into three buckets. The first bucket goes towards covering the cost of your insurance (death benefit).

The second bucket goes towards covering the costs of fees and administrative expenses that the insurance company charges. The third bucket goes into the cash value component of the policy. Your cash value will earn a fixed rate of return from the insurance company and can be used in a variety of ways.

Your cash value will earn a return that is guaranteed to grow at a fixed rate by your insurer. The portion of your premium that goes into cash value is typically invested in conservative yield investments by your insurer which is how your cash value earns interest. Think of cash value as a savings account within your whole life insurance policy.  

Your cash value also has the potential to earn higher returns than the guaranteed rate on your policy depending upon how the underlying investments perform. Keep in mind that these above average returns are not guaranteed by the insurer.

It is also important to understand that the cash value portion of your policy is a tax deferred vehicle. This means that you won't owe any taxes on the interest earned within the account as long as the money stays in the account.

Unlike cash that is deposited into a bank account that will show up almost immediately, the cash value portion of a whole life insurance policy takes time to build. The reason for this is that your insurer allocates more of your premium towards the cost of your insurance (death benefit) and administrative fees in the earlier years of your policy.

Over time, more of your premium will go towards cash value and your balance will start to grow. Depending upon how your policy is structured this can take anywhere from 5 to 7 years. However, you might be asking yourself a more pressing question. How can you use the cash value of a whole life insurance policy?

1) Borrow against the cash value - Whole life insurance policies are designed in a way in which you can borrow against the value of your cash value. For example, let's say you have had a whole life insurance policy for the last 10 years and have a cash value of $100,000.

If it makes sense for you to do so, you can borrow against your $100,000 of cash value. It is important to note that we say that you borrow "against" your cash value as whole life insurance loans are collateral loans. When you take out a loan against your cash value, the money does not leave that account.

Instead, the insurance company lends you their money and uses your death benefit as collateral. What does this mean exactly? Let's assume again that you have $100,000 of cash value in your policy and decide to borrow $20,000.

The $20,000 is not subtracted from your cash value. It is instead given to you by the insurance company. So, the entire $100,000 stays in your cash value account as opposed to $20,000 being taken out of the account which would leave you with an account balance of $80,000.

This means that as you borrow $20,000 from the insurance company, your entire $100,000 of cash value stays in your account and continues to earn interest and grow. However, the insurance company will charge you interest on the money they loan you.

They typically charge a slightly higher interest rate on the money you borrow than the interest that you are earning on your cash value. For example, let's say that your $100,000 cash value balance was earning interest at a 3% rate. If you borrow $20,000 you would likely be charged 4% or 5% to borrow that money.

So, what can you use a policy loan for? Anything you want. If you have sufficient funds in your cash value account, your insurance company is obligated to provide you with the funds that you desire. You could use the funds to finance a car, start a business, upgrade your home, etc.

As you have likely gathered, life insurance policy loans are not your typical loan. So, what are the requirements to pay back the loan? Unlike traditional bank loans, whole life insurance policy loans do not have a set schedule to pay the loan back.

For example, let's say that you were going to finance the purchase of a car. If you were to get traditional bank financing, you would be required to repay the loan on a set monthly basis. A life insurance policy loan does not require you to pay back the loan on a set schedule which gives you more flexibility to pay back the loan.

Additionally, whole life insurance policy loans do not necessarily have to be paid back. Remember how we said that life insurance companies issue policy loans and use your death benefit as collateral? This allows your death benefit to cover any outstanding policy loans that you may have.

So, how does this work? Let's say that you bought a whole life insurance policy with a death benefit of $500,000. As you aged, you borrowed from your cash value to supplement your income or finance purchases. When you passed away, you had an outstanding policy loan balance of $200,000 that had accrued from loans and interest.

Your life insurance company would subtract this outstanding loan balance from your death benefit to "pay back" the loan. This means that your $200,000 loan balance would be taken away from your $500,000 death benefit and your beneficiaries would receive a death benefit of $300,000.

Keep in mind that you must be very careful with this concept. If your loan balance becomes greater then your death benefit, the policy can blow up and you can face all sorts of consequences. In general, whole life policy loans can be advantageous when used properly.

However, it is extremely important to understand the complexities of a whole life policy loan so that you do not get yourself in financial trouble. Working with an experienced life insurance agent can help you navigate life insurance policy loans.

2) Withdraw from the cash value - If you would rather pull money directly out of your cash value account as opposed to taking a loan, you are able to do so. A cash value account is a deferred tax vehicle which protects the interest you earn from taxes if you keep the money in the account.

However, as you take a withdraw the money inside is leaving your tax deferred savings vehicle which can trigger taxes. Taxes are typically only applied to the interest that you have earned in the account. For example, let's say that you have held onto a whole life insurance policy for 7 years and have built up $50,000 of cash value.

Let's assume that $40,000 of this came from the premiums that you paid into the policy and $10,000 came from interest you earned within the account. Only the $10,000 would be taxable as that is money that you earned. The rest of your account balance came from premium payments which had already been taxed.

It should also be noted that withdrawing money from your cash value account reduces the amount of death benefit coverage you have by the same amount. For example, let's say that you bought a whole life policy with $500,000 of death benefit and had built up your cash value to $100,000. If you were to take a withdrawal of $25,000 from your cash value, your death benefit payout would be reduced to $475,000.

3) Surrender the policy and take the cash value - It is possible to surrender the policy and take the cash value that you have built up. Essentially, you are deciding to not protect your life anymore and are giving up your death benefit coverage. In exchange, you get to keep your cash value.

If you decide to do this, you might be charged fees or a surrender charge by your insurer depending upon how long you have had the policy for. Additionally, you can owe taxes on any interest that your cash value earned if you surrender the policy.

4) Pay for your insurance costs - If you have sufficient cash value, you can use it to cover the cost of your insurance premiums. For example, let's say that your whole life policy costs you $500 per month. Let's also assume that you have about $20,000 worth of cash value.

If money gets tight from unexpected bills one month, you might be worried about whether you would be able to cover your $500 policy cost. However, since you have enough cash value, you can cover your policy cost from your cash value as you sort out your own personal finances.

1) Coverage duration - The primary difference between term and whole life insurance is the coverage duration. Term life insurance only covers you for the set amount of time that you select. Typical coverage durations for term life insurance are 5, 10, 15, 20, 25, or 30 years.

Whole life insurance on the other hand covers you for your entire life. For example, if you bought a whole life insurance policy at 25 years old, you would still be covered when you are 75 years old if you pay your premiums to maintain the policy.

2) Cost - Since whole life insurance has a guaranteed death benefit and a cash value component, it is more expensive than term life insurance. For some individuals, the extra benefits that whole life insurance offers justify the higher cost.

Keep in mind that the exact amount of money you pay for life insurance depends on a multitude of factors whether you buy a term or whole life insurance policy. These can include your age, your health, your family health history, the amount of coverage you purchase, whether you smoke, and more.  

3) Cash value - Whole life insurance builds cash value, and term life insurance does not. Term life insurance only offers a death benefit. The cash value component of a whole life insurance policy can be integrated into a financial plan, but it is a complex financial product. Understanding the point of a whole life insurance policy is key before buying one.

The generic advice you will hear is to pick term life insurance if you only need temporary coverage and want the most bang for your buck. Individuals often purchase term life insurance to protect their loved ones during the times in which their loved ones depend on them the most.

For example, say that John is 30 years old, and is married with a couple of young children. John has a mortgage, and his wife stays home to take care of their children. John recognizes the need to have life insurance to protect his wife and children in case he was to die.

He decides that he wants a term life insurance policy that will protect his family until they are less dependent upon him. Say that John had 25 years left to pay on his mortgage and that it was going to take 20 years for his kids to be financially independent from him.

For this reason, he decides to purchase a 25 year term life insurance policy. This will allow him to protect his loved ones during a period of vulnerability while being able to get a substantial amount of coverage at an affordable cost.

The downside to picking a term life insurance policy is that you will likely not use it. In the example above, John purchased a 25 year term life insurance policy when he was 30 years old. When the term policy ends, John will be 55 years old.

In all likelihood John will still be alive when his term policy ends. This does not mean that a term life insurance policy is a waste of money. If John ended up passing away, his family would be grateful he had a term policy.

However, if John wants to guarantee that the money he puts into life insurance will go to his family, he could opt to buy a whole life insurance policy over a term life insurance policy. A whole life insurance policy is a way to guarantee that John will leave his family money no matter when he dies.

Whole life insurance will allow John and his wife to do something else financially - spend all their other financial assets in retirement. Say that John and his wife are financially savvy and have been steadily investing for their retirement through a 401k and Roth IRA.

If John buys a whole life insurance policy, it will allow himself and his wife to spend all their assets in their 401k and Roth IRA when they retire. Since a whole life insurance policy is guaranteed to pay out, John has already taken care of leaving his kids money.

This allows John and his wife to full enjoy the fruits of their labor in retirement as they won't be worried about leaving their kids money from their 401k or Roth IRA. Beyond a guaranteed death benefit, whole life insurance also builds cash value.

Due to the cash value component, whole life insurance can be referred to as an investment.  Although whole life insurance has investment attributes, it should not be compared to traditional investments. The cash value of whole life insurance exists so that you can access capital throughout your life to seize investment opportunities when they arise.

For example, we know that John and his wife are saving for their retirement through a Roth IRA and 401k. Although each of these accounts has benefits, they both share a drawback. John will not be able to access the money in these accounts until he is 59 and a half years old. (There are exceptions to this rule.)

If John needed access to a considerable sum of money, he would not be able to get it from these accounts. However, if he had a whole life insurance policy, he could access money from it whenever he wanted for whatever purpose he wanted.

The point here is that a whole life insurance policy can be a good fit if you want a guaranteed death benefit, and a financial product that gives you access to money when you need it. Keep in mind that the tradeoff for these benefits is a higher cost when compared to term life insurance.

At this point, you likely understand that both term and whole life insurance have their advantages and disadvantages. Term life insurance is cheaper which means you can buy more coverage per dollar. The disadvantage is that you will likely not need to use a term life insurance policy.

Whole life insurance is more expensive than term life insurance but has the advantage of a guaranteed death benefit and a cash value component that you can use while you are still alive. Choosing one over the other can be a difficult decision which is why it can make sense to combine both term and whole life insurance to meet your needs.

Let's once again revisit the example of John. We have gone over scenarios in which it would make sense for John to pick a term or whole life insurance policy However, John can also consider a third possible option - combine the two policies.

We know that John is married with a couple of young kids and has a mortgage. Say that John wants to enough life insurance to cover his mortgage and give his wife 10 years of income as she does not work because she takes care of their children.

If John has a $500,000 mortgage and makes $100,000 per year, he will want at least $1.5 million in life insurance. John could buy a 25 year term life insurance policy for $1.5 million to cover his mortgage and wife's financial needs if he were to die.

The advantage to this is that John would be able to get life insurance coverage to protect major liabilities for a cheap cost. However, John plans to be alive at the end of end of his 25 year old term. Since term life insurance only covers you for a set time, John would no longer have life insurance when he is 55 years old.

For this reason John also purchases a $500,000 whole life insurance policy. This guarantees that $500,000 will be paid out to his loved ones and will allow John to build cash value over time that he can use while he is still alive.

This strategy allows John to do a few things. First, the term policy protects his wife and children when they are most reliant upon him for a more affordable cost. As his children grow up and become adults, they will no longer be financially dependent upon John.

Over time, John will also be paying down his mortgage which means he will not need as much coverage in the future. The term policy covers these financial obligations that John has when he is young. Second, the whole life insurance policy allows John to have lifelong coverage.

This allows John the feeling that the money he puts into life insurance will not be wasted. Whole life insurance can also help John in other financial aspects due to the cash value it builds over time. By combining term and whole life insurance John can take advantage of the benefits of each type of policy, while minimizing the downsides of each type of policy.

The bottom line is term life insurance covers you for a set period which typically ranges from 10 to 30 years. If you die during the term, your death benefit will be paid out to your beneficiary(s). If you do not die during the term, your coverage will end.

Whole life insurance on the other hand covers you for your entire life and builds cash value along the way. Both types of policies have advantages and disadvantages. Term life insurance is cheap, but only provides coverage for a set term.

Whole life insurance is more expensive but has a guaranteed death benefit and cash value. For some individuals, term is best. For others, whole life is best. You can also consider combining both types of coverages to take advantage of the benefits of both.

At the end of the day, it is important to pick the policy that you believe will meet your needs. Working with a competent life insurance agent can help better explain your options so that you can make the most informed decision.