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Life insurance falls into two broad categories, and data shows many households aren’t purchasing the most cost-effective coverage.
Americans purchased 4.1 million term insurance policies in 2021, accounting for 40% of all individual policies purchased that year, according to the most recent data available data From the American Council of Life Insurance Companies. About 6.3 million policies, or 60%, are permanent life insurance.
But that doesn’t seem to line up with general advice from financial advisors.
“Most people just need term insurance,” says Carolyn McClanahan, a licensed financial planner in Jacksonville, Fla., and a member of CNBC’s advisory board.
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What is the difference between term life insurance and permanent life insurance
Life insurance is a form of financial protection that pays out money to beneficiaries, such as children or a spouse, if the policyholder dies.
Term insurance pays a death benefit only for a certain period of time (maybe 10, 20 or 30 years). Coverage will lapse after that time unless renewed.
By contrast, permanent insurance policies, such as whole life and universal life, provide continuous coverage until the policyholder’s death.they are also called Cash value policies because they have interest-bearing accounts.
Permanent insurance is usually more expensive, consultants say. Premiums are spread over a longer period of time and these payments are used to pay for insurance and build up cash value.
“Term insurance may be the most cost-effective way to address the income needs of survivors, especially minor children,” said Marguerita Cheng, CFP in Gaithersburg, Maryland, and CNBC advisory board member.
Premiums vary from person to person. Insurance companies base coverage on the policy’s face value as well as the policyholder’s age, gender, health, family medical history, occupation, lifestyle, and other factors.
Reasons You May Need Permanent Life Insurance
Despite the higher premiums, buying a permanent policy may make more sense for three reasons, according to McClanahan, founder of Life Planning Partners. The purpose of this is to ensure that no matter when the death occurs, the insurance payout will be obtained.
For example, some beneficiaries, such as children with special needs, may need long-term financial help for which the policyholder’s lifetime savings are insufficient to meet their needs, McClanahan said.
Some policyholders may also want to leave a financial legacy for family or charity. Also, others may experience relatively minor health complications that are likely to worsen later. By then, policyholders may not be covered, in which case it would be beneficial to buy a permanent policy today to ensure coverage later, McClanahan said.
Most people only need term insurance.
Caroline McClanahan
Life Planning Partner Founder
Some shoppers buy permanent life insurance based on cash value, thinking they can use that cash value to borrow money or use it as a retirement savings account.But McClanahan said it was a “terrible reason” to buy a permanent policy, adding The main reason for buying a policy is always for insurance needs.
One, there may be Taxes and Penalties Used to obtain the cash value of the policy. Withdrawing or borrowing too much money from a permanent policy can cause the policy to inadvertently lapse, meaning the owner loses coverage.
McClanahan said policyholders should think of the cash value as an emergency fund at the end of life, as the last asset someone draws on, similar to home equity.
How to determine the amount and term of life insurance
Cheng, CEO of Blue Ocean Global Wealth, said potential buyers should consider the “three L’s” when deciding how much life insurance to buy: liability, loved ones and inheritance.
For example, if you die, how much are you willing to leave behind to pay off debts like your mortgage, student loan, or car loan? How much do loved ones like spouses and children need if they suddenly lose the policyholder’s income? How much are you willing to leave behind for causes that are important to you?
Thinking about these issues will help guide the policy’s deadline, Cheng said.
Cheng cited her personal situation as an example. When her three children were all under 18, she purchased a 20-year term policy that included a $750,000 death benefit. Her husband also works and has a regular income. If Cheng Ying died young, each child will receive 250,000 US dollars in education funds. She also purchased $250,000 of permanent insurance specifically for Cheng’s husband to help them pay off their mortgage.
Combining term and permanent insurance can make buying insurance more cost-effective than buying permanent alone, consultants say.
Advisers say those buying term policies should make sure they buy “convertible” term insurance. This gives policyholders the option to convert their term policy to a permanent policy after the term ends without requiring another round of medical coverage. At that point, if the person is in poor health, coverage may be denied.
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