As I’ve continued to write about finance, I’ve put even more effort into my own personal finances. One of the areas that I’ve been neglecting is our insurance setup. We currently have whole life insurance for both Kelsey and myself. Our whole life insurance was always something that I wasn’t quite sure we needed but I never sat down to actually do the research until now. Boy, am I glad I did.
Life Insurance Basics
First, let’s talk about what life insurance is and what kinds are out there.
Life insurance is essentially money to be paid if you were to pass away while the policy was in effect. Say you purchased a policy with a $100,000 benefit. This policy may be in effect for 30 years and to keep the policy, you would pay a set premium each month. If you died while you had this policy, whoever you designated as a beneficiary (spouse, children, relatives, or close friends), would be paid $100,000 by the insurance company. If you have people who depend on your income for basic living expenses, life insurance is a good way to ensure that those who depend on you would be taken care of financially if you passed away.
There are two main types of life insurance: term and whole.
Term life insurance is essentially what was described above. After your policy period is up, you can decide to renew it at the current rates or you can forego it and move on with your life without the coverage.
Whole life insurance adds a savings/investing portion to the plan. With whole life insurance, you pay a larger premium for the ability to build “cash value.” This means that your policy acts kind of like a savings/investing account in that it accumulates funds. After a period of time, you may start to have a significant cash value that you can borrow against. Alternatively, you can “cash out” the policy by cancelling and getting a check for the cash value. Depending on your specific plan details, the cash value of your policy will grow with a preset formula or it will be dependent on the performance of investment markets. Given enough time, your cash value will actually be worth more than your total premiums paid into the policy.
As I said, Kelsey and I each have a whole life insurance policy. Our policy builds cash value over time. We’ve had our policy for 2.5 years and if we were to keep it for another 10 years or so, our cash value would be the same as the total of all our premium payments. After that, our cash value would outpace our premium payments.
You might be thinking that sounds great. You essentially get life insurance for free. That was what I thought as well, but that’s not quite the case.
You see, the additional portion added onto whole life insurance brings the monthly premium way up. For example, as a relatively healthy 27-year-old, I could purchase a $100,000 30 year term life insurance plan for $13/month. My current $100,000 whole life insurance plan costs $100/month!
But what about the cash value in my policy? If I’m paying such a large premium, I should be getting a good return on my investment, right? Indeed, as of this writing, my policy has a cash value of $1,219.86. That’s been my return on $3,000 worth of premiums.
If this was an investment plan (it really is), it would be performing terribly! A better way to get my insurance needs would be to buy a cheap term life insurance plan and invest the amount I would have put into a whole life plan. Let me show you why.
Crunching the Numbers
As I said, my whole life insurance plan costs me $100/month. When I signed up for the plan, I was given estimates on how my cash value would build over time. I pulled up those estimates and found that my cash value is lagging slightly behind what the estimates said. I should be around $1,360, but the estimates are close enough that I can use them for the purposes of this analysis. If anything, it’ll make the whole life option look better than it actually is.
With the estimates I was given, after having the policy for 30 years I would have paid $36,000 and the cash value for my insurance would be just around $60,000. At that rate, it comes out to about a 3.3% annual return. This is just barely above the rate of inflation!
Now let’s look at what would happen if I went with a term life policy. Instead of $100/month, I’d only pay $13/month. I could then take that $87/month and invest it in the stock market, which I’ve said repeatedly, averages 9% annually over the long run. With this setup, in 30 years, I would have only paid $4,680 and my investment account would be worth nearly $160,000. That’s the same as the cash value for whole life except with an extra 1 in front!
But let’s be really sure that term life is the way to go. If we stack the deck against term life by assuming sub-par returns of 7% on our investments and a premium of $20/month, our lifetime premiums paid would only be $7,220 and our investment account would still be worth considerably more at $98,000! And remember, I’m already using high-end estimates for the whole life policy cash value!
When I purchased the policy, I told myself that it’s not a bad deal since I’m also getting the cash value. After doing the math, I can see that it was a terrible deal. I’m essentially giving a 30 year loan to the insurance company that hardly keeps up with inflation. I would be much better off taking a cheaper term policy and starting to build my “cash value” in my own investment accounts. If you have a whole life policy, you should definitely make the switch to a term life insurance plan. That’s exactly what I’m going to do this week.
UPDATE: See how my conversation with my financial advisor went in my follow-up article, Term Vs. Whole Life Insurance Part 2