The life insurance industry offers several different flavors of life insurance to meet the various coverage needs and financial goals of clients. But which life insurance policy is for you? Let's run through the major types of life plans and their respective pros and cons.
Term Life Insurance
Term life insurance is by far the most popular type of life insurance policy. It's called "term" life insurance because the policyholder is covered for a specific length of time, typically 30 years. Term life insurance is also called "pure" life insurance, because your monthly premiums only pay for a death benefit, not any kind of investment component.
Term life insurance is so popular because it fulfills the most basic need for life insurance, which is to replace lost income following the death of a spouse, parent or other financial provider. People often buy term life insurance when they get married or have a child, because they want a policy that will cover them through retirement age, or until their children are financially independent.
Because term life insurance only pays out a death benefit, and because it only provides coverage for a limited time, the premiums are generally much less expensive than other types of life insurance. According to Policy Genius, a healthy person in their 20s or 30s can expect to pay between $30 and $40 a month for a 30-year term life policy with a $500,000 death benefit.
Pros: The chief benefits of term life insurance are low monthly premiums and the peace of mind that survivors will receive a substantial death benefit if the policyholder dies young.
Cons: The downside of term life is that it only covers the policyholder for 30 or 40 years, so survivors receive no death benefit if the policyholder dies after the term has expired.
Whole Life Insurance
Whole life insurance falls under the larger umbrella of "permanent" life insurance policies. Unlike term life insurance, which only covers the policyholder for a 30- or 40-year term, permanent life insurance policies are, well, permanent — the policyholder is covered for their entire life. As we'll see, though, that extra coverage comes at a cost.
Whole life insurance is the simplest type of permanent life insurance. There are two components to a whole life insurance policy: the death benefit and the "cash value."
The death benefit component of a whole life policy works exactly the same as term life insurance, except there's no expiration date. No matter when the policyholder dies — unexpectedly at 35 or understandably at 95 — their beneficiaries receive the death benefit.
The cash value component of whole life insurance policies is basically a savings account that grows with interest. Part of your fixed monthly premium with whole life insurance goes toward the death benefit and part goes into this savings account.
Pros: The benefits of whole life insurance are lifetime coverage, fixed monthly premiums and extra cash stashed away in a savings account. And before you die, you can withdraw money tax-free from the savings account up to the cash value you've contributed.
Cons: The main downside of whole life insurance is its cost. You'll pay six to 10 times more in premiums compared to term life for the same death benefit. As for the savings account, financial experts like Dave Ramsey say you'd get a much better return by investing that same money in a mutual fund.
"Permanent life insurance policies get the cold shoulder by some in the financial-planning community who say, 'Why not buy term and invest the difference?'" says Jack Dolan, vice president of public affairs at the American Council of Life Insurers (ACLI). "The truth is, a lot of people buy term and they spend the difference."
Universal Life Insurance
Universal life insurance is another type of permanent life insurance policy. It's very similar to whole life insurance in that there's a death benefit component and a cash value component. The difference is that universal life offers more flexibility in how to pay the monthly premiums.
The major selling point of universal life insurance is that you can potentially use the accumulated cash value of the account to lower the cost of monthly premiums or pay for them entirely. Dolan says that this type of policy is most appealing to people whose income varies from year to year. If money is tight one year, universal life insurance policyholders can dip into their savings account to help pay for the premiums.
Pros: The benefits of universal life are permanent coverage and flexible out-of-pocket costs for paying the monthly premiums.
Cons: Management fees are higher than whole life, and if your cash value account runs low, you may not have the funds to cover the monthly premium, rendering the policy void.
Variable-Universal Life Insurance
Even Dolan admits that variable-universal life insurance is "not for everyone." Variable-universal life insurance is similar to straight universal life insurance, but instead of accruing cash value in a savings account, you invest the money in "sub accounts" that are similar to mutual funds.
As a policyholder, you can choose which sub accounts to invest your money based on the risk level you're comfortable with, or you can have a life insurance agent manage the investments for you. Either way, there's far more inherent risk with these mutual fund-style investment vehicles than with a simple savings account.
Like a universal life insurance policy, though, you can use the accrued cash value of a variable-universal policy to lower the cost of monthly premiums or pay them entirely. Assuming the investments pan out and the cash value grows over time.
Pros: If you're comfortable with the risk and prefer to have hands-on involvement with your investments, a variable-universal policy might be an attractive option. Dolan says that variable-universal policies are typically picked by "higher-income individuals."
Cons: Dave Ramsey calls variable-universal policies "one of the worst life insurance options on the market" because of their high management fees, poor performance compared to other investments and the fact that the policyholder assumes all risk for the investments, not the insurance company.
Other Types of Life Insurance
In addition to term life insurance and permanent life insurance, there are a few alternative and less-common types of life insurance.
Joint Life Insurance: This is a life insurance policy (usually permanent, not term) that covers more than one person, often a married couple. With a "first-to-die" policy, the surviving spouse is paid a death benefit if their husband or wife dies. With a "second-to-die" policy, the death benefit is paid out when the second policyholder dies. In those cases, the children or other beneficiaries get the death benefit. Second-to-die policies are sometimes used to manage estate and inheritance taxes.
Mortgage Life Insurance: These policies are marketed as a way to pay off a mortgage if the main financial breadwinner passes away. Most financial planners agree, however, that mortgage life insurance is a bad investment. Premiums can spike unexpectedly and the value of the policy actually goes down as time passes, since the balance on the mortgage reduces year after year.
Credit Life Insurance: Like mortgage life insurance, credit life insurance is designed to pay off the balance of a specific loan — home equity loan, car loan, etc. — if the policyholder dies. The benefit of such a policy is the peace of mind of knowing that the debt won't be passed on to surviving family members. The drawbacks are that the value of the policy decreases over time even as premiums stay the same, and that the real beneficiary is the lender, not the survivors.
Final Expense Insurance: You've probably seen the touching ads for this one on TV. This insurance takes care of any costs associated with one's funeral and burial, so your loved ones aren't stuck with the expenses. It may pay out anywhere between $5,000 and $25,000 for usually a small amount of money in premiums. However, many experts say it's a bad deal. You could probably get the same benefit without buying a policy, simply by putting away $50 a month toward funeral expenses in a savings account. Or you might be able to get a term life policy with a lot more benefits for the same monthly premium.
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