Buy term and invest the difference?
It’s been debated for generations: Term vs. perm? Here’s a new twist on an age-old idea.
If you’re shopping for life insurance, you’ve undoubtedly heard the argument to purchase a lower cost term insurance policy and invest the difference rather than choosing a permanent life insurance policy. This approach may be well suited for some people, but for others it may not make sound financial sense. New York Life recently commissioned some academic research on this topic, working with a professor from the Wharton Business School. You’ll want to make an informed decision, so it’s best to discuss your needs and options with an insurance professional. Before you make up your mind, you’ll want to consider the following questions:
Which type of life insurance is best for you?
No matter what you may have read in financial advice columns, there is no one “best” type of life insurance. What’s best is what is best for you. Life insurance is not a “one size fits all” product. There is a wide range of permanent life insurance products to choose from, including whole life, modified premium whole life, survivorship whole life, and universal life, each with its own particular benefits, which can be tailored to suit your particular needs.
Term life insurance may be right for people on a budget. It can also serve as a short-term, stopgap means of pure protection. Later, as life changes occur, the term policy can be converted to permanent insurance. When all is taken into consideration, you may find that a term insurance with a conversion privilege is best for you.
How long do you need life insurance coverage?
Most would say they need the security of life insurance for their entire lives. Life insurance can help pay off a mortgage, fund a college education, take care of final expenses, offset the loss of the insured’s income, and allow your loved ones to continue their standard of living. Both term and permanent insurance can provide those benefits, but which one can do it most efficiently over the course of a lifetime?
With a permanent product such as whole life, premiums are fixed—they can never be increased by the insurer—and your coverage can never be canceled provided premiums are paid when due. With term policies, your premiums are set for a predetermined period (one year, five years, etc.), then increase in subsequent years. With a premium increase at each renewal, the cumulative cost of term over the course of several decades may well bypass that of a comparable whole life policy. In addition, with some term policies, you may be required to submit evidence of continued good health with each renewal. This may put you in danger of being uninsurable when the term coverage is up for renewal.
Renting or owning?The well-known analogy of a term policy as “renting” and a permanent policy as “owning” is a good way to illustrate their true values. When you rent a house, you receive all the benefits of living in that house. However, when your lease is up, you have built up no equity. The same is true of a term insurance policy.
Conversely, with a permanent policy, you build guaranteed cash values that you may tap into through loans.1 In addition, as an owner of permanent insurance, you may be eligible for dividends,2 if and when they are declared by the insurance company. These dividends may be used in a number of ways, including applying them to purchase paid-up additional insurance, which can increase your overall coverage with no additional out-of-pocket expense.
Invest the difference in what?Investing wisely is a key factor in determining the success of “buy term and invest the difference.” If you choose term insurance, you’ll have to decide where to invest your leftover money. Products such as mutual funds and individual stocks and bonds are options. Of course, with these types of assets your return will vary based on market conditions; and when you redeem your shares, they may be worth more or less than you originally paid.
If you are risk averse or very close to retirement, this volatility may not be right for you. Also, capital gains, if any, are taxable when distributed. Certificates of Deposit (CDs) are a less risky option as they pay fixed interest and is FDIC insured up to $250,000, but they could have withdrawal restrictions and their return may not be as high as you’d like. With permanent insurance, in addition to death benefit, your policy builds guaranteed cash value that in the long-term could accumulate to a significant sum. These funds accumulate on a tax-deferred basis, and if your need for life insurance decreases, they can be conveniently accessed through policy loans that are usually non-taxable.1 Permanent life insurance has another key tax advantage: the proceeds that flow to beneficiaries are generally free from federal income tax.
The choice is yoursFor some, “buy term and invest the difference” may be a legitimate option. While for others, permanent insurance is the way to go. Your decision is a personal one, based on your family’s budget, needs, and goals.
The insurance and financial decisions you make now are crucial to your family’s future, so be sure to do your homework. Read up on the benefits of all of the types of life insurance and financial products you are considering, and discuss your options with your agent.
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1 Policy loans accrue interest at the current interest rate and will reduce the death benefit and the cash value by the outstanding loan and accrued loan interest.
2 Dividends are based on the policy’s applicable dividend scale or interest crediting rate which is neither guaranteed nor an estimate of future performance.