In this post we help you reduce the risk of buying more life insurance than you actually need.
It's one of most common questions for first time shoppers: what kind of life insurance should I buy? If you can answer this question, you'll find the rest of the decision making process much easier.
There are two general rules of thumb to keep in mind when shopping for life insurance.
Trick #1: Buy term, not permanent
The first is to decide which kind to buy, and the choice here is pretty simple. Unless you're wealthy enough to need a custom-fitted estate plan (for tax and inheritance issues), stick to "term" life insurance policies—ones that last from 5-30 years, for example—and avoid what are called "whole" or "permanent" insurance types.
You'll see push-back against this advice both online and in person from some brokers and agents, but there are several reasons why "stick with term" is the go-to advice most mainstream financial advisors give. Permanent insurance has an investment component to it, so there's a chance some of the money you pay into it (the "cash value" portion, not the full amount) will earn a return over the life of the policy, which you can then use to offset your premiums, increase your benefit, or partially cash out (minus any fees). While this might sound appealing at first, consider the following:
The premiums are much higher than they are for term, which leaves you with less money to invest elsewhere, which matters because...
...401(k), IRA, and 529 savings plans are all more flexible and direct ways to build tax-protected savings.
The complexity of a permanent policy makes it hard to accurately calculate and understand the risk involved, especially for the potential payoff.
There's a good chance you'll walk away from the policy in the first 10 years (nearly half of new policyholders do) because of the expense.
And although your agent or broker is awesome, the fact remains that the commission for selling a permanent policy is much higher (think 10 times higher) than it is for a term policy, which invariably leads to a conflict of interest.
And on it goes. If you want more, head over to The White Coat Investor, where Jim Dahle debunks over a dozen more myths, including whether permanent insurance is a good way to pay for college (it isn't), whether it really can protect your assets from creditors (not always!), and whether it's a good asset class to diversify your portfolio (nope).
One final argument you may hear for permanent over term is that permanent means you'll still have your life insurance right up until the end, assuming you live a long and happy life. But that's not really important, because...
Trick #2: Only buy enough to cover your actual needs
Lots of people get hung up about buying insurance in general because they see it as a sunk cost with little payoff. Of course that's the whole point of insurance—if you’re getting the benefit, it means something has probably gone wrong. Still, it feels unsatisfying because when we pay for something, we expect to "get" something in return.
With term life insurance, when the policy ends in 5-30 years, so does your coverage. Permanent life insurance is happy to step in and offer a tempting alternative: "Buy me and you're guaranteed to get a death benefit no matter when you die!" But as noted above, there are too many reasons not to buy permanent life insurance to overcome this one feature, which it turns out is of questionable value in the first place.
To understand why, stop thinking that you need life insurance your whole life and instead think about the real financial burdens you'd leave behind if you died now—a mortgage loan, child care, college tuition for your children. Then look at when those burdens will come to an end—when the mortgage is paid off, when your child becomes an adult, when your children have graduated from college. See that period between now and when those burdens go away? That's when you need life insurance the most.
If you look at your life in terms of stages, with different financial resources and needs as you move from your first job to raising a family to retirement, you'll see that other than health insurance it's likely that you'll need other insurance products only for portions of your life. With life insurance in particular, there comes a time for most people when your biggest financial burdens have been met, which reduces the need for life insurance protection considerably.
Wrapping up: you are a snowflake
As with any discussion around personal finance, there will be exceptions to the two rules of thumb above. If you've got an unusual situation, you're probably better off going to a financial advisor for some face-to-face strategic planning.
For most of us, though, the best approach is to keep things simple. If the main reason you're buying life insurance right now is because it's on your to-do checklist of building financial security (as it should be), stick with the two tricks above to get the best bang for your buck. And be sure to read our guide to buying life insurance for more tips and insider advice on what to expect.
Photo credit: Robert McGoldrick