Myths On Money

Before you begin reading this post, please refer to some of the terms used when talking about life insurance.

• What is Term?
• Why Buy It?
• Pricing Factors
• Drawbacks
• My Recommendation

What is Term?

Term life insurance is life insurance that you pay for over a fixed time period (or term). When you buy term insurance you specify the time frame, usually 5, 10, 15 or 30 years, but the term can vary. Each month for the term of the policy, you pay a monthly payment. This payment is fixed for the full term of the policy. As long as you make your payment, your policy remains in force. At the end of the policy term, the policy expires. Many term policies have provisions that allow you to renew the policy for a new term, but there are drawbacks to renewing, which will be discussed later.

Why Buy It?

The reasons to buy term life insurance are few, but compelling.

1. It’s cheap! A traditional whole life policy with a death benefit of $100,000 for a healthy 25 year old male can cost around $65/month. Term life insurance for the same individual could run somewhere around $10-$15/month. The difference in cost widens as the death benefit grows. As a general rule, term insurance can cost 50-70% less than permanent types of life insurance. This cost difference can be invested in your retirement account to grow at the market rate (10-12%). In the long run, the cost difference can provide hundred of thousands of dollars in retirement income.
2. It terminates. This may not seem like a good thing, but it really is. Think about it, if life insurance proceeds are intended to supplement your family’s income after you die, then what need have you of life insurance when you are 60 or 70 years old? Hopefully by then, your kids are independent and your retirement is secured by the funds you have saved all your working life. Your spouse can subsist off your retirement savings (else you would not be retired!). So why should your family need an extra hundreds of thousands of dollars should you die? The benefit of term insurance is that after the term is expired, you don’t have to pay for it any more. If you get a long term on the policy, then by the time the term elapses you should not need any life insurance at all. You will be self-insured. Permanent types of life insurance (contrary to what your agent might tell you) require payment to be made on them until the day you die. That payment may not come out of your pocket, but it will come out of the savings you have accumulated within the policy (more on permanent types of life insurance in future posts). Those costs hurt, and (with some types of permanent insurance) they can continue to rise as you age.
3. The cost is fixed. The premium for term insurance is fixed when the policy is issued. The premium does not change over the course of the term of the policy. This is good because it makes the costs of the insurance predictable.

Pricing Factors

There are a few factors which contribute to the premium cost of a term insurance policy.

• Death Benefit The higher the death benefit, the higher the premium.
• Your Health The better health you are in, the lower your premium. Remember that this premium is fixed at the time you purchase the policy, so the better health you are in when you buy the policy, the longer you can take advantage of your health. Age is a large factor when your health is considered. The younger you are, the cheaper the policy will be. This is one reason to buy insurance as soon as possible.
• The Term The downside to buying early is that you generally have to stretch out the term longer. The longer the term, the higher the premium. So there is a bit of a trade-off between your age and the term of the policy. The younger you are when you buy the policy, the longer the term of the policy you will need to get. However, in most cases, the higher cost for the longer term is less than the savings for youth.
• Your Lifestyle In most cases, your lifestyle will have no effect on your life insurance premiums, but if you engage in activities that are dangerous and potentially fatal (such as sky diving or other extreme sports), your premium can increase dramatically. Lifestyle choices that affect your health, such as smoking, are also factored in when the insurer looks at your overall health.

Drawbacks

• Prone to Lapse If you fail to make a premium payment, then a term insurance may lapse. Insurance agents will tell you (when they are trying to convince you to buy a costly policy) that a low percentage of term policies ever pay out the death benefit. This, according to them, is explained through the following scenario: the insured is sick/injured in the hospital for a couple months and the family, in their grief, neglects to make their premium payment and the policy lapses right before the insured dies. This argument is very misleading, and a prime example of first-rate sales techniques. First off, grace periods are typical with life insurance policies. These grace periods are usually about 30 days. ( Reference ) If you miss a payment for any reason, you have 30 days to make the payment before the policy lapses. If you make the payment, then your policy maintains it’s validity, and if the insured dies, the death benefit will be paid out. This argument plays on your emotions and your ties to your loved ones to convince you to buy a policy that could possibly quadruple the agent’s commission. Don’t fall for it. If the insured is sick for more than two months, the beneficiaries will have plenty of time to make sure all of their affairs are in order (including making sure that insurance premiums are paid). I think the primary reason that few term insurance policies pay out the death benefit is because the insured survives the term of the policy. Remember that term policies can sometimes be as short as 6 months or a year. If the insured does not die during the term, then the policy will not pay out the benefit. I think you can see how short-term policies can scew the percentage of term policies that pay out. Regardless, if you outlive the term of your policy, does that mean that you lose? If you live a long life and outlive the term on the policy, does that mean you made a bad decision? No! You win! You got cheap insurance for as long as you needed it, and you got to live long enough to enjoy the benefits of the cost savings! That is the best outcome that could be hoped for.
• No Forced Savings One of the benefits of permanent insurance is that it forces you to save money. Every month you get a bill from the insurance company that says you must pay your premium. Part of that premium goes into savings to earn interest. With a term policy, you are solely responsible to make sure you are investing your cost savings. This takes willpower and effort, but it will pay out better in the long run.

My Recommendation

I recommend that most people should get a term insurance policy, and invest the difference in cost. Get the policy while you are young (twenties preferably) and get a long term (20-30 years); the goal is to have the policy last until your savings are sufficient that your family will not need additional funds upon your death. If, and ONLY IF, you invest the cost savings and establish a healthy savings habit, you should have plenty of money after 30 years that you can be self insured. At that point, let the policy close out, and enjoy not having any insurance payments for the rest of your life. If you would rather have the safety of knowing that the insurance company will require you to make savings deposits, then you probably should look at some form of permanent insurance.

Before we get into the various types of life insurance, let’s go over a few terms that you are likely to run in to when you are looking at life insurance.

Premium

The premium is the monthly payment that you are required to make to the insurance company.

Lapse

A lapsed policy is a policy that is no longer in force, typically because the insured failed to make the appropriate premium payments. Lapsed policies can often be reinstated if the missed premiums are paid up.

Beneficiary

The beneficiary(ies) is the person to whom the insurance company will pay the death benefit to when the person who is insured dies.

Death Benefit

The death benefit of a policy is the amount of money that wil be paid by the life insurance company upon the death of the person insured. The higher the death benefit, the higher the premiums will be.

Permanent Insurance

Permanent types of life insurance are policies that not only provide insurance, but also have a cash-value account associated with them. These policies do not lapse or expire until the cash value is depleted.

Term Insurance

Term insurance is insurance that is purchased for a specific term. It has no cash-value or savings component.

Surrender Value

The surrender value of a permanent life insurance policy is the amount of money that you will receive if you decide to close the policy. The surrender value is typically very very low in the first 10-15 years.

Cash Value

The cash value of a permanent life insurance policy is money that you have paid to the insurance company that they hold for you. These funds are held in a large variety of interest bearing accounts which earn a wide variety of interest rates, depending on the type of permanent life insurance policy you purchased. More on the cash value as we discuss the types of permanent life insurance in later posts.

1. Why Life Insurance?
2. When Should I Buy?
3. How Much Should I Buy?

Why Life Insurance?

Firstly, be aware that life insurance is something that you buy without the intention to ever use it. If you buy a policy on yourself, do you really want to cash it out? The second thing to remember is that life insurance is something that you purchase for others. It is not something you get for yourself. If your life insurance policy is paying out, then you are not going to be around to get the benefit. The last basic principle is that having your policy pay out the benefit is NOT winning against the insurance company. Some people feel that they don’t want to pay for something that is never going to pay out. They get into a competition with the insurance company. They feel that somehow they have to get some cash out of the insurance company in order to come out ahead.

But the thing to remember is that life insurance IS insurance. Like rent, insurance is something that you pay for that gives you something in return, but not necessarily cash. When you buy insurance, you are buying protection. In the case of life insurance, you are buying protection for your loved ones in the event that you should die. So just remember, not ever using your life insurance policy means that you WIN, not that you lose. It means you get to live, and I call that a victory.

You should buy life insurance to help those who depend on you for financial support. Should you die, they will need the benefit from the insurance to help them to subsist while they get back on their feet. Life insurance can be used to pay off significant debts, provide a college fund for children, and to supplement survivor’s income.

When Should I Buy?

Since life insurance is something that you buy to protect your dependents, you don’t really need life insurance if you have no dependents. Who are your dependents? A spouse whose income cannot meet the family’s needs, children, perhaps siblings with disabilities, sometimes even parents who rely on your income to help support them. Basically, it is anybody who depends on your income. So, for some people, no life insurance is needed.

There is, however, at least one reason to buy insurance even when you don’t need it. Insurance rates are cheaper the less likely you are to die. That means that the younger you are, the cheaper the life insurance is. Many types of life insurance allow you to lock in your rates when the policy is first formed. If you buy young, you may be able to lock in a low rate for your entire life.

How Much Life Insurance Should I Buy?

This question is impossible to answer for everyone at once. Perhaps more so than any other financial question, this one requires a close look at your precise situation. But here are a few guidelines to help you get started.

• Cover your debts
  You want your dependents to be able to keep all of their possessions without having to worry about losing it to the bank. You will want to pay off the mortgage on your home so that your family can have a place to live without the stress of a mortgage. You may also want to repay car loans, student loans, etc.
• Provide a college fund
  This is more optional than covering debts. You will need enough coverage to provide for the funds to be invested to grow until they are needed. This is a complex calculation because the inflating cost of college must be calculated across every year the child will be in college for each child, and the amount you need to invest needs to grow at a certain rate to provide the right amounts of money at the right time.
• Supplemental income
  In order to help replace the value of your work experience, the interest that your funds earn can become supplemental income to your family. Another thing to consider is the possibility of increased living expenses for your family after your death. A big one would be day care. If you have small children, your spouse (now widowed) would have to work to support the family, which means that they would not be able to stay home with the children. The cost of day care can be huge, and your life insurance can help offset that cost, or pay for it outright. There are other possible expenses. Perhaps the family may need a family therapist to help them cope with their loss, perhaps you die in a car accident and now the family needs a new car. There may be medical bills if others were in the car, or there may be your own medical expenses to cover. These are all things to be aware of.

Knowing your basic sources of life insurance needs is where you need to start. Each of these life insurance needs need to be discounted and applied within financial calculations in order to ensure that you have the correct amount that your loved ones will need. These calculations are tough, and require a careful analysis. You want to be careful not to purchase too much life insurance because the more you buy, the more it costs. I recommend consulting a financial planner (NOT an insurance salesman) to determine your exact life insurance needs. To aid you in your quest, you will find a new calculator on the downloads page that can help you get a rough estimate of your life insurance needs.