What are the different types of life insurance?
Basically, there are two main categories of life insurance: term and whole, also called universal life. There’s final expense insurance too, which we talked about in the “why you should buy life insurance” section above, but that’s a specific type of policy that doesn’t really fit into either of these two categories. Below are brief descriptions of term and whole life insurance to help you understand the main differences between them. You can learn more about each type of insurance at the links provided. Those will take you to the corresponding page on our website that goes into more detail.
Term life insurance
When you buy term life insurance, sometimes also known as “pure” life insurance, you’re buying a policy that gives you coverage for a certain amount of time, such as 10 years, 20 years, or 30 years, as long as you continue to pay the monthly premiums. A term life policy has what is called a “level” death benefit, which means the amount the insurance company will pay to your beneficiaries upon your death is the same whether you die shortly after buying the policy or many years later.
The main advantage to buying a term life insurance policy is the cost. It’s usually less expensive than buying a whole life policy for the same amount of coverage. For many people, a term life policy costs about as much as a monthly phone bill. This makes term life insurance particularly attractive to younger people who might just be starting a family or establishing a new career. It’s also a good option for those who might be a little older and are the head of their household. In a situation like that, the person could buy a policy with a 20-year term to protect the family until he or she reaches retirement age. At the end of the 20-year term the policy would expire, with no need to renew.
Term life insurance is very expensive to renew, so we generally do not recommend doing that. There are better alternatives, such as making sure the term life policy you buy includes a conversion option.
Learn more about term life insurance
Whole life insurance
With a whole life insurance policy, also called a universal life policy, you’re buying life insurance coverage for the remainder of your life — at least in theory. This type of insurance protects your family and is an investment as well. In other words, the money you pay each month to keep the policy active (i.e., your premium) earns a certain rate of return, kind of like a savings account that earns interest.
There are two parts to a universal life insurance policy: the premium and the investment portion. The premiums for a universal life insurance policy increase every year, just like they do for a term life policy. The amount you can earn on the investment portion of a universal life policy depends on what type you buy:
Guaranteed universal life insurance
This type of policy typically guarantees a 4% rate of return on the investment portion of the policy. Using this guaranteed 4% rate of return, the insurance company calculates the minimum monthly premiums required to keep the policy active until you would reach the age of 121.
A guaranteed universal life insurance policy is a good choice when you want to have a permanent policy at the lowest cost. These policies typically give you the option to overfund, which means you can pay more premiums than required so you can build more cash value at a 4% rate of return.
This is the type of policy type we recommend for people who want whole life coverage because it has the best value for a permanent policy.
Indexed universal life insurance
This is also a permanent policy, but unlike a guaranteed universal life insurance policy that pays a flat rate of return, an indexed universal life policy is linked to a stock index, such as the S&P 500. It offers cash savings within the policy and the opportunity to follow market trends.
Part of the premium for this type of policy is used to invest in the chosen index. So, the policy builds value based on that index.
Most of the time, this type of policy is sold with a guarantee that it will not lose money. The downside is that it also is capped, which means there’s a limit on how much you can gain by having a policy like this.
You can borrow money from the investment portion of an indexed universal life insurance policy, but you must repay the loan. Otherwise, the death benefit will decrease by the amount that has been borrowed but not repaid.
These policies can be a good choice for people who have set aside as much as they can in their retirement accounts and want another way to invest while deferring taxes. But, these policies can be complicated. We believe they are oversold to consumers, and we always recommend seeking the advice of a financial advisor before buying an indexed universal life insurance policy.
Variable universal life insurance
This type of universal life insurance has the same features as basic universal life insurance, but with an extra “variable” component. That component has a cash value that’s invested in small sub-accounts, which act similar to a mutual fund. The cash value can increase or decrease, depending on the kind of investments made. It’s important to note that the income in this account can be lost entirely.
As with indexed universal life insurance, people who might benefit from this type of policy are those who have already maxed out the contributions to their retirement accounts but want to invest in a tax-deferred vehicle. An agent who sells variable universal life insurance policies must be licensed to sell stocks and bonds.
Learn more about whole life insurance