Myths On Money

In this post…

The Word on the Street:

Whenever someone wishes to make a large purchase on credit (like a house or a car), the lender will often try to sell them an insurance policy. These policies are supposed to protect your family from having to repay the loan in case the buyer dies.

The Truth:

This insurance does not truly protect you or your family. Why do you think they press the issue so hard? Is the car salesman or the dealership really out there to do you favors? No. They are out there to make a profit. And there’s nothing wrong with that. But, as a consumer, you ought to be aware that credit insurance really only benefits the lender. When you buy credit insurance, you are in fact guarantying your lender that it’s loan will be repaid. You are paying their insurance premium!

What is Credit Insurance?

The insurance that the salesman/banker will try to sell you is a type of insurance called credit insurance, although they may not call it that. What credit insurance does is pay off the remaining balance of your loan if you should die. If the loan is sufficiently large (like in a mortgage) and you meet certain criteria, a lender may require you to purchase this insurance before they will issue the loan. This is a typical arrangement for mortgages where the buyer has only a small down payment. When it comes to auto loans, these policies are usually discretionary, and will often be paid for with one large premium payment at the time of purchase. This post focuses on discretionary insurance for auto loans, rather than potentially mandatory insurance for mortgages.

How they sell it

When making a large purchase, people have a tendency to downplay the magnitude of some costs. They figure, “I’m already paying $20,000, what’s another $400 more?” By exploiting this tendency, car salesmen are often able to convince the buyer that the cost of the insurance is a small price to pay. They bury the cost within the larger cost of the car and make it seem as though it is a good deal.

This next tactic is downright cruel. What the salesman will tell you is that this insurance will protect your family from having to pay off the loan should you die. He tries to convince you that your family will be left financially bereft by having to continue to make the car payment. By playing on the emotional bonds within your family, he impairs your rational judgment within a cloud of powerful emotions. This is how they convince you that this insurance is a good deal, and will benefit your family.

Don’t fall for it

It’s true that your family will receive the money to pay off the loan, and that will benefit them. It’s also true that you ought to use life insurance to help pay off your debts so your family can be free of them should you die. So why shouldn’t you get the credit insurance?

Short answer:

It’s way over priced!

Long Answer:

An example. Suppose Herb buys a $20,000 car, taking out a $15,000 loan for 4 years. The dealer offers credit insurance to cover the loan in case he dies. The policy is available for an up-front cost of $500, which they offer to include with his loan. Is this insurance a good deal? Assuming Herb is 35 years old and in good health, for $125 per year over a 4-year period, Herb could purchase a traditional level term life policy for at least $100,000 coverage. So, for $500, he could have $15,000 of declining life insurance (to cover the car loan) for 4 years, or for $500 ($125/year for 4 years) he could have $100,000 of coverage that he could keep that his family could use any way they wish, should he die. Dollar for dollar, the credit life insurance is much more expensive. If you are considering buying a car and wish to cover the loan in case you die, you would be much better off purchasing traditional, term life insurance than you would to buy the credit insurance the dealer may offer you.

• What is Whole Life?
• Benefits
• Drawbacks
• My Recommendation

What is Whole Life?

Whole life insurance is the most basic form of permanent life insurance. It is basically a term life insurance policy combined with a fixed-yield savings account. This savings account usually yields an interest rate around 2-5%, but grows tax-deferred, similar to your IRA. When the proceeds are withdrawn, they are taxed, but they are not taxed year to year. The premium of a whole life policy has essentially two parts: one part covers the cost of the insurance, the other goes into your cash value account tied to the life insurance policy. I am not going to go into extensive detail as to how these policies work, as there are better resources for that. Rather, I will focus my attention on specific benefits and drawbacks of whole life policies.

Benefits

1. Flexibility.
   It can be difficult to talk broadly about whole life policies because there are so many riders and options you can take to truly customize a whole life policy to your needs. These riders and options are a plus, though, because they allow you to cusomize your insurance coverage and cash value account as you progress through your life.
2. Permanence.
   Because whole life policies are a form of permanent insurance, they do not expire after a given time frame. This means that you will have coverage over the course of your entire life, so long as you continue to make payments on the policy. The cash value of the policy also helps provide a degree of stability to the policy; as long as your cash value is sufficient to pay the premium, the policy will not lapse. If you fail to make a premium payment, then the payment is simply withdrawn from your cash value.
3. Forced Savings.
   If you struggle to set aside funds for the future, then a whole life policy can help force you to save. Because a portion of each premium payment goes into your cash value account, you are essentially getting a bill each month from the insurance company demanding that you make a certain deposit to your cash account. This can make it easier for some people to set aside the funds that they will need to save. These savings also grow tax-deferred, which is an excellent bonus.

Drawbacks

1. Low Return.
   While the interest earned on the cash account is guaranteed and tax-deferred, the actual rate of return tends to be disappointingly low.

   All of the $93 per month disappears in commissions and expenses for the first 3 years. After that, the return will average 2.6% per year for whole life, 4.2% for universal life, and 7.4% for the new-and-improved variable life policy that includes mutual funds, according to Consumer Federation of America, Kiplinger’s Personal Finance, and Fortune magazines. The same mutual funds outside of the policy average 12%.
   Dave Ramsey

2. Expensive.
   As we just saw in the Dave Ramsey quote above, there are high costs to permanent insurance of any kind, whole life included. The expenses of managing and maintaining these accounts, paying (large) commissions to the sales agents, etc make these policies very inefficient. Whole life policies can be double or even thrice as expensive as an equivalent term insurance policy. You get way more bang for your buck from a term insurance policy.
3. Permanence.
   While permanence can be considered a benefit of whole life policies, it’s also a double edged sword. One of the great lies of the life insurance industry is that after “some point” in the future, you can stop paying premiums on your policy. This, the customer interprets to mean that the policy is free after that point because the cash value grows faster than the premiums come out. That’s true, but highly deceptive in nature. You see, when you sign up for a whole life policy, you agree to pay premiums on that policy for the rest of your life. Just because you reach a point where you need not write a check for the premium does not mean that you are not charged for the policy. So, if you are planning on using your cash value to live off in retirement, you had better plan on continuing to pay your premium out of that fund, because it’s automatically set to auto-pay the insurance company. And you wondered why insurance companies LOVE espousing these policies….

My Recommendation

In my opinion, whole life policies are among the worst life insurance policies that a person could get. If you want permanent life insurance and the benefit of forces savings and tax-deferred growth, then there are better forms of insurance out there for you. Whole life policies can be good for the very wealthy (who are unlikely to be reading this blog) to protect their vast estates when they die, but for most people, they are not a great option.

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.