Term life insurance vs. permanent life insurance: Is cash value the best value?

If you're looking for life insurance, aside from considering how much you need, you'll find the need to understand and possibly choose between the two basic types: term life insurance and cash value life insurance.

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The main difference between the two is that term life insurance covers you relatively inexpensively for a set period, whereas cash value life insurance covers you at a much higher cost for the remainder of your life. Cash value life insurance costs considerably more than term life insurance, depending on age and health, but adds a cash value component of debatable merit.

How do term and cash value life insurance work?

Term life insurance generally offers the most amount of coverage for the least amount of money, and is the appropriate choice for most people. The most common reason to buy life insurance is to replace a person's income in case of early death, and term life insurance is the cheapest and best way to do that. Term life insurance is also an especially good choice for people and families who are just starting out, because it's relatively cheap and provides a lot of protection when replacing income is most important.

Cash value life insurance, also called permanent or whole life insurance, offers protection for your entire life (as long as you pay your premiums) and more flexibility than term life insurance. However, it usually comes at a much higher price. For example, the premium for a cash value policy can easily be 10 or more times higher than a term policy with the same level of coverage. The feature that makes permanent life insurance different is its ability to gain cash value. A portion of the money you pay into your premium goes into a cash value portion that grows over time, and becomes available for your use after a certain period.

How does cash value work?

The portion of your payment that goes toward the policy's cash value is very large in the beginning, but decreases slowly as time goes on. That's because permanent life insurance payments are made up of two parts: the regular insurance premium, which is comparable to the premium amount for the same coverage in a term life policy, and the cash value, or "overpayment" amount. The overpayment money is invested by the insurance company and later used to pay for the higher costs of insurance as you get older. In this way, the company is able to keep your premiums the same instead of increasing them over time. At a certain time, this cash value amount becomes available for your use.

A very common way people use their cash value is by taking out a loan against their policy. This loan draws from the cash value amount and uses the face value (or death benefit) of the policy as collateral, and is usually not subject to credit checks. You don't have to pay it back, but the initial amount, plus interest, will be taken out of your death benefit if you die, resulting in a lower payout. Another consideration is that the loan amount may be taxable if it is worth more than what you have paid in premiums.

Although many insurance agents recommend cash value policies because of the ability to use the cash value portion, their tax-advantaged status, and their retirement and savings features, most people can gain these same advantages with other forms of retirement and savings without the drawbacks and high prices of cash value insurance. Also, remember that there are usually penalties, or "surrender charges" for canceling a cash value policy in its early years.

The cash value component of a policy can work differently and be used for different things depending on the type of permanent life insurance you choose. There are four main variations: whole (or ordinary) life, universal (or adjustable) life, variable life, and variable universal life.

• Whole life insurance is a predictable policy that provides a guaranteed benefit, a guaranteed earnings rate on your cash value, and a level premium. You may also earn dividends based on how well the company performs. Whole life is the most basic kind of permanent life insurance.
• Universal life insurance is a flexible option that lets you vary your premium payments. After the first premium, you can usually make payments at any time. If you have extra money, you can pay more. If you can't afford to make a payment, you can skip it or pay less. The cash value portion usually operates in a similar manner as with whole life insurance. A problem with universal life is that if you don't make enough payments, or the company does not perform as expected, your policy could lapse. Newer types of universal life policies include guarantees that this will not happen, so be sure that you explore this option. Universal life can be one of the cheapest forms of permanent life insurance.
• Variable life insurance allows you to invest your policy premiums. The problem with this is that if the investments perform poorly, the death benefit and cash value will decrease. On the other hand, if the investments perform well, the death benefit and cash value can greatly exceed those of a normal policy. Variable life is one of the most risky forms of permanent insurance, although its rewards can be great as well.
• Variable universal life insurance, as its name implies, is a combination of variable and universal life insurance. It allows you to vary your payments, invest your policy premiums, and vary your coverage amount. Variable universal life insurance is the most flexible type of permanent life insurance, and can be either risky or predictable, depending on how you use it.

Making the choice

Most financial planning experts recommend term life insurance in almost all circumstances. You could potentially benefit from a cash value life insurance policy, but it's very likely that you'll overpay for what you get in return. You can receive almost all the retirement and investment benefits of permanent life insurance through traditional means, such as a 401(k) account, IRAs, bonds, etc. Even if you can afford the premiums for cash value insurance, you're probably better off buying the same amount of term life insurance and investing the difference.

If you're still unsure, remember that many term life insurance policies offer a conversion feature. This option will allow you to change the term life policy to a permanent life policy, either during a set period or at any point in the term. Some policies even allow you to credit some of the term premiums you've already paid toward your permanent life insurance policy.

If you're ready to make your decision, remember that term life insurance is a relatively cheap way to get protection for a set period, and is almost always the better choice.

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Originally posted September 20, 2004.