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The Big Difference Between Whole and Term Life Insurance

Financial technology companies - "fintech" to those in the industry - reframed the way we think about financial decisions. We became more self-directed with our money, and the nature of advice changed once we were able to do transactions with a few clicks.
07/13/2016 04:17pm ET | Updated July 14, 2017
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This article was written by Jennifer Fitzgerald, CEO of PolicyGenius.

Financial technology companies - "fintech" to those in the industry - reframed the way we think about financial decisions. We became more self-directed with our money, and the nature of advice changed once we were able to do transactions with a few clicks.

Why hire a tax preparer when you can use TurboTax to fill out your taxes step-by-step on your own? Who needs a financial advisor when Acorns and similar apps will invest your spare change automatically?

Insurance is following suit. The mission of PolicyGenius is to get people the insurance they need and make them feel good about it, and one of the best ways to do that is through education. But sometimes you can't beat having an expert to direct questions toward, and some of those questions never change.

Even today, the number one question we get is, "What's the difference between whole life insurance and term life insurance?"

There's actually an easy way to remember this: term is for a set period of time (aka term) and whole is designed to cover you for your whole life.

But the returns of whole life insurance isn't clear upfront and it's usually not worth the buy-in. By choosing whole over term life insurance, you could end up spending a lot more money and dealing with a lot more stress.

Term life insurance and you

Term life insurance is what we like to call "pure" life insurance because when you pay your monthly (or annual) premium, you're just paying for the cost of the death benefit to your survivors. When we get to whole life insurance, you'll see that that's not always the case.

Because there aren't many extra frills, term life insurance is cheap. If you're relatively healthy and in your 20s or early 30s, you can get a 30 year/$500,000 policy for as little as $30-40 a month. That's barely more than the price of the Tidal subscription, but you get something a lot more worthwhile out of it.

Besides being affordable, term life insurance is also pretty straightforward. Again, you're only getting the protection of a death benefit, so there's not a lot of fine print. There are only two things you really need to be aware of: the contestability period and the suicide clause.

The contestability period lasts for the first two years of the policy and lets the insurance company contest any claim that may raise suspicions of application fraud in the event of your untimely death. But after two years, the contestability period expires and the death benefit will be paid if you die during the policy term. The suicide clause also applies to the first two years of your policy; a death benefit won't be paid if the cause of death is suicide during the first two years.

In short, the first two years of your policy are subject to extra scrutiny for fraud, but besides that you're pretty much in the clear. That's why term life insurance is the best option for 80-90% of people looking to protect their families from the worst.

The whole truth

Whole life insurance is a type of permanent insurance, which means it comes with a cash value. That sounds like a great thing, right? Who doesn't want cash?

You don't. Or, rather, you shouldn't when it comes to whole life insurance, because it comes at a price.

The price here is literal: whole life insurance can cost as much as four times more annually than term life insurance. You're looking at possibly well over a hundred dollars a month for the same amount of coverage you could be getting for a fraction of the price.

Why the big price hike? Because instead of being pure life insurance, with whole life insurance your premiums are split between the life insurance and a savings vehicle - the cash value. The savings accrues interest, just like most savings accounts, but in this case the interest is a dividend from the insurer's profits.

Thanks to fees and other costs not associated with other investment vehicles, along with reliance on fixed investments like bonds, the growth of the cash value portion of a whole life insurance policy is lower than other investments. But many have a guaranteed return that make them attractive, especially in times of economic uncertainty (see: the 2008 recession).

Confused? Don't worry, it gets worse.

If you surrender the policy too soon - usually within the first 10 years - you could risk losing money thanks to high surrender charges. You can borrow from the cash value with a policy loan, but you'll have to pay interest on it (and typically can't deduct the interest paid on your tax return like you can with other interest payments). Plus, while the cash value increases over the life of the policy, the death benefit actually decreases.

Between the cash value component and the variety of riders, fees, and stipulations that come with a whole life insurance policy, a lot of people walk in thinking they're getting a great deal and walk out with a headache. But just because they're not right for everyone doesn't mean they aren't right for anyone.

If you have enough assets that you have complex financial needs, or you're going to need the cash value of a whole life insurance policy to cover, say, your endowment plan or estate plan, then congratulations! You're probably able to afford a whole life insurance plan, and the extras that come along with it can help cover your specific financial situation.

If you have a pushy financial adviser, you might also fall into the camp of someone who has a whole life insurance policy. He'll tell you it's in your best interest because it forces you to save and since you're a human being there's a high probability you're bad with money. He probably won't mention that, with the higher premiums, he'll get a higher commission so it's also in his best interest for you to have a more expensive policy.

Funny how they rarely seem to bring that up.

It's cliche to say that everyone's situation is different, but that's the truth. You're probably going to get all of the protection your family needs with an affordable term life insurance policy, but you may fall into the small subset of people for whom a whole life policy is the right choice.

The most important thing to do is arm yourself with knowledge and compare policies before making any decisions. Since life insurance is a decision that affects you for decades to come, it's something you might want to take a minute to look into.

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PolicyGenius is rethinking insurance from the consumer's perspective - because it's about time somebody did. We're making it easy to learn about, shop for and buy insurance. Our digital insurance advisor and online quote engines for life insurance, pet insurance, renters insurance and long-term disability insurance will help you to get the coverage you need.