While considering insurance coverage, you may hear the mantra "buy term and invest the difference." That might be good advice in some circumstances, but it's best to evaluate all of the alternatives and understand the benefits and stipulations of each choice.
Here's what it means to buy term and invest the difference, how it differs from other life insurance options, and how it might relate to your specific financial needs.
Term vs. Permanent: Know Your Options
There are two primary types of life insurance: term policies and permanent policies.
Term life insurance policies last for a specified number of years. For example, 30-year term covers you for up to 30 years, as long as you continue paying premiums, and you can stop paying premiums if you decide you no longer need coverage. Your coverage ends when the term ends, and you'll need to apply for a new policy if you want continued coverage.
Permanent policies can last your entire life, as long as you continue to pay the premium to keep the insurance in force. Universal life, one form of permanent policy, features a cash value, which you might build up in the policy's early years and then use to pay insurance costs in later years. If you build up more cash value than you need to pay for insurance coverage, you may be able to draw on those funds for other financial goals (like retirement income or college tuition).
Monthly and annual premiums are typically higher for permanent policies in part because you're building up the cash value. But at the same time, that cash value may help reduce the insurance company's risk — along with insurance costs.
That's where the debate over term life insurance (or buying term and investing the difference) and permanent insurance comes in: Should you pay higher premiums in pursuit of permanent coverage and future cash values, or should you buy term and invest the additional money that would have gone toward permanent insurance premiums?
Why You Might Buy Term
The main reason you might choose to buy term is that you may be able to minimize insurance premiums and costs. That may be beneficial in a few situations:
- Instead of paying higher monthly or annual insurance premiums, you'd have funds available to save and invest for other financial goals.
- If you found you no longer needed coverage, you could stop paying premiums and cancel your coverage. You could then redirect those payments toward other needs and goals.
- If you're an aggressive investor with a higher tolerance for risk, you could choose to try to grow your assets through investments. There's no guarantee on investments, however, so you could end up losing money, or fail to end up with as much as your policy's cash value over time.
Why You Might Buy Permanent
The approach described above might make sense for basic life insurance needs that you know are temporary. For example, if you're otherwise protected, but you just want extra coverage until your child becomes financially independent, a term policy could do the trick at a lower cost.
But not every situation is that straightforward. Permanent insurance might be a better fit for some in the following cases:
- Permanent needs: If you want permanent coverage, permanent insurance might be the best strategy. For example, you may want a guaranteed death benefit to leave a legacy for family members. A permanent policy could also help when you have estate planning needs or illiquid assets at death.
- Forced savings: If you won't actually invest the difference (many people don't), permanent insurance provides "forced savings" that help you build assets over your lifetime. That strategy may be particularly helpful when it's difficult to prioritize financial goals.
- Potential tax benefits: Cash value life insurance may help provide a tax-free source of funds later in life. Using policy loans or withdrawals, you may be able to draw on your cash value without creating a tax liability. However, be careful about letting the policy lapse after taking out a loan, as this could have tax consequences.
- Creditor protection: Depending on your needs and state law, any cash value in life insurance policies may enjoy creditor protection. Although plans like individual retirement accounts (IRAs) may also be protected, non-retirement assets could be at risk.
- Future Insurability: You can't predict the future, and you can't know for sure if you'll need life insurance later in life. Buying a permanent policy when you're young and healthy can help you secure coverage in case your health declines (which could make it difficult or impractical to buy coverage later on). Generally, the only other way to protect insurability is with a term policy that offers an option to eventually convert to permanent coverage.
It All Depends on Your Needs
Term insurance can ease the burden on your monthly budget and help provide essential protection against the death of a breadwinner. But permanent insurance has its place when your needs don't fit that mold or when you're using more advanced planning strategies. Ultimately, which approach is the best fit within your broader financial plan depends on your specific situation. It's often a good idea to talk with a financial representative to help determine what's right for you.