Updated: Oct 17, 2018
This will be a topic of controversy, but I feel it’s vital that I address it. I want to first say that life insurance is ABSOLUTELY needed! However, life insurance policies can be very complexed and oversold, so it’s important that you understand what you are buying. As many of you may know, nothing grinds my gears more than life insurance agents calling themselves “Financial Advisors.” They are NOT! They are nothing more than life insurance agents who can only sell you (and many times oversell you) life insurance. The problem is most American can’t tell the difference and become victim to a scheme that can cost them hundreds of thousands! I don’t solely blame the life insurance agent for being the pushy salesman that he is, I blame the industry itself. Life insurance agents are paid off commission, meaning the more money you spend on a policy, the more they get paid. So can you really blame them for wanting you to pay as much as possible? After all, they do have a family to feed. My goal here is not to shun life insurance agents, but it’s to equip you with the knowledge needed to purchase the right amount of insurance you need at the right price.
Before we dive into the trap and how to avoid it, let’s first understand the difference between the two main types of life insurance, “Term life insurance” and “Permanent (whole) life insurance:
Term Life Insurance:
Term life insurance provides coverage for a certain time-period “term.” It’s often called “pure life insurance” because it’s designed only to protect your dependents in case you die prematurely. If you have a term policy and die within the term, your beneficiaries receive the payout. The policy has no other value. You choose the term when you buy the policy. Common terms are 10, 20 or 30 years. With most policies, the payout, called the death benefit, and the cost, or premium, stay the same throughout the term.
Whole Life Insurance:
Like all permanent life insurance policies, whole life provides lifelong coverage and includes an investment component known as the policy’s cash value. The cash value grows slowly, tax-deferred, meaning you won’t pay taxes on its gains while they’re accumulating. Whole life insurance comes at a cost though, on average about 10x more per month than a term policy of the same amount. You can borrow money against the account or surrender the policy for the cash. But if you don’t repay policy loans with interest, you’ll reduce your death benefit, and if you surrender the policy, you’ll no longer have coverage. Also, the cash value generally doesn’t begin until between the about the 2nd or 3rd year of the policy.
So which one is best for you? There aren't many absolute answers in personal finance but for 95% of people, especially for my millennials, there absolutely no reason to get permanent insurance. A term policy will be about 10x cheaper and give you the coverage you need for the duration you will need it. In fact, buying an expensive whole life policy could really damage your chances at financial independence. Take this life insurance comparison between John and Joe:
John (Whole Life) Joe (30 Year-Term)
Start date: 1/1/2012 Start Date: 1/1/2012
Death Benefit: $250,000 Death Benefit: $250,000
Yearly Premium: $3,100 Yearly Premium: $204
Total Premium Paid: $20,666 Total Premium Paid: $1,360
Cash value: $12,360 Excess cash invested: $33,873
From our example, we can see that Joe pay 15x less a year for the same amount of insurance that Joe has. Also, after just over 6 years Joe has accumulated $21,513 more than John due to his insurance savings! If we were to project this over a 30-year-period, the difference in wealth would be astronomical. However, the key is to INVEST THOSE SAVINGS! If you can’t trust yourself to use your savings wisely than you may fall in that 5% that would be better off with permanent insurance.
Now that we know which type of insurance to purchase, how much do we need? There are many rules of thumb out there (10x your salary, 5x your salary, the total of your debts) but it really depends on your situation. For example, if you are single and no one depends on your income then having enough insurance to cover your outstanding debt + funeral cost is sufficient. However, if you are the breadwinner in your family and have 2 kids who depend on your income then maybe 10x-15x your salary should be your range. Whatever the case you should always have some amount of insurance. As the saying goes, “It’s best to have and not need, then to need and not have.”