How whole life insurance can leave you underinsured

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How whole life insurance can leave you underinsured

Just about everyone knows they need life insurance – the “just in case” coverage you buy and hope you’ll never need. While people often get some life insurance coverage through their employer, many purchase supplemental policies to have coverage tailored to their lifestyle.

But how much should you buy? Some experts suggest you purchase five to ten times your income in life insurance coverage. However, there are instances where you might need more (or less). If you have young children, many working years left or lots of debts and liabilities, for example, you might consider eschewing the rule of thumb and purchasing a policy tailored just for you. (At Policygenius, we actually recommend this needs-based approach to estimating how much life insurance you should buy, but it’s important to keep the industry’s common rule of thumb in mind for the purposes of this article.)

What type of life insurance should you buy?

Here’s where things get tricky: Which type of life insurance should you buy? While there are several variations of life insurance plans, there are two main types of policies – term life and whole life insurance.

Term life insurance is the most popular type of coverage because it’s more affordable and less complex. With a term life insurance policy, you pay a monthly premium for a set length of time – usually 20 to 30 years. During that time, you’ll have a set amount of coverage. On the flip side, your policy is basically done and over with the day it expires. So, if you die one day outside of your term life insurance policy, your family is out of luck.

Whole life insurance works differently because it is meant to last your entire life. You pay a monthly premium that builds up cash value over time, and you are guaranteed a fixed benefit (so long as you pay your premiums) until the day you pass away.

The downside with whole life insurance is it’s expensive – and sometimes prohibitively so.

How whole life insurance can leave you underinsured

Unfortunately, the high costs of whole life insurance can wind up pushing people into policies that aren’t comprehensive enough. It’s not that they don’t want to buy more coverage; it’s that, with whole life being so expensive, they have to purchase a smaller policy to get the monthly payment in line with the rest of their budget.

Sometimes, the salespeople who sell whole life policies won’t tell you that. Instead, they’ll explain the virtues of a policy that builds cash value – and how the lifetime benefit gives peace of mind. Of course, they’ll also explain how many whole life policies pay out dividends, which they do. But they may not encourage you to compare those potential dividends to how much you pay for your policy over time.

How much more does whole life insurance cost? At the end of the day, it really depends. Since life insurance premiums are based on age, health, state of residence, and other factors, prices are truly all over the place.

Whole life insurance, a case study

To come up with an example, I used a life insurance calculator to get sample rates for myself – a 37-year-old woman in Indiana. I’m in good health and of an average weight, so I would likely qualify for the good rates. But honestly, the disparity between the term life and whole life policies I was quoted as a guesstimate shocked me.

A 20-year, term life insurance policy for $750,000 might set me back as little as $49.35 per month. But a whole life insurance policy would cost me $908.10 per month – or $10,437.50 per year!

Now, let’s imagine someone in my shoes who earns $100,000 per year on the dot. Buying $750,000 in life insurance coverage might be the minimum she would consider because it’s 7.5 times her annual income.

Obviously, someone who earns $100,000 per year probably can’t afford to pay nearly 10% of their pre-tax income in life insurance premiums. To save money, she might lower the amount of coverage she buys.

To get the monthly payment to an affordable range, she whittles her coverage down to $300,000. That way, she can pay more like $365 per month.

That’s great because she’s saving money, but it’s likely leaving her underinsured. Keep in mind that $300,000 is only 3x her annual income – not even close to the five to ten times your salary most experts recommend.

Conversely, for less than $50 per month (or even less if she price-shopped with another insurer), she could buy $750,000 in coverage that lasts 20 years – or until she’s 57. That would be enough to replace most of her income for her working years, and wouldn’t put her family in financial peril if she passed away.

This, my friends, is how whole life insurance lets people down – even if it’s a good product. The fact that it can be so expensive forces people to reduce their level of coverage to score lower monthly payments. That in itself is dangerous, mostly because forgoing needed coverage defeats the whole purpose of buying life insurance to begin with.

When is whole life insurance right for you?

Having said that, there are times when whole life insurance is a good fit. For instance, high net-worth individuals might want to take advantage of certain tax benefits associated with a policy. Most notably, its death benefit isn’t subject to income tax, so it creates a tax-free inheritance for beneficiaries.

If you’re in the market for a new life insurance policy, make sure to compare several types of policies and their costs (Policygenius can actually help you do so across life insurance companies). While it would be great to have a policy that lasts forever, it won’t do you much good if you can’t afford to pay premiums for the level of coverage you need.

Image: Vesnaandjic