Here’s what you need to know about life insurance.
- Life insurance provides financial support for your family in the event you die.
- Life insurance can replace your income, pay off debts, or cover future expenses.
- Usually, you don’t need life insurance until you start a family.
- But, the younger and healthier you are when you get coverage, the cheaper it will be.
- There are two kinds of life insurance:
- term life insurance or
- whole life insurance (a.k.a. “cash value” life insurance).
- We nearly always recommend term life insurance.
- Buying life insurance involves:
- Getting free quotes online,
- completing an application with the help of an agent,
- getting a mini physical exam (usually conducted at your home by a traveling nurse), and
- paying your first premium.
Common Myths About Life Insurance for Young People
As soon as you start a family, life insurance becomes a critical part of your financial plan. And the younger you are, the more affordable life insurance is to buy. Life insurance for young people isn’t different; it just costs less for obvious reasons: young people have longer life expectancies and are, on average, healthier than older populations.
So what do you need to know about life insurance? First of all, I want to dispel a couple of myths:
- Myth 1: Nobody needs life insurance in their twenties, but everybody needs life insurance when they get older.
- Myth 2: Certain types of life insurance are a smart way to build wealth.
Fact #1: You Only Life Insurance If You Have Dependents
Don’t base the decision to purchase a life insurance policy on age. If you’re under 30 and already have two children, unless you’re already wealthy, you should have life insurance. You may be healthy, but accidents happen, and the responsible thing to do is to leave your children with something. On the flip side, if you’re 30, 40, or even 50, and single, you probably not need life insurance. If you kick the bucket, so what? Your salary wasn’t putting a roof over anybody’s head but your own.
As soon as you have a child, you need to start thinking about life insurance. You only need to carry life insurance until your oldest child moves out (or finishes college, if you want to help provide for higher education) or you will have saved enough to provide for your family if you die. (If you’re investing wisely, you will hopefully have significant assets in 20 or 30 years). And with guaranteed level term life insurance, the younger and healthier you are when you purchase policy, the less you pay for the entire 20 or 30 years you carry the policy.
There’s one situation in which you might want to buy life insurance even if you don’t have a dependent spouse or children: If you somebody cosigned your student loans or another large debt. For example, if your mother co-signed student loan and you pass away, she will be on the hook for the remaining balance. In this case, a very modest amount of term life insurance could enable your mother to pay off the loan in the event you die.
Fact #2: Term Life Insurance Is Best For Most People
Unfortunately, about 61 percent of life insurance policies sold in the United States in 2010 are whole (or cash value) life insurance policies as opposed to term life insurance policies, according to the 2011 American Council of Life Insurer’s Fact Book. What’s the difference?
Cash Value Life Insurance
With a whole or cash value policy, you pay regular premiums to the insurer and the insurer invests your premiums (minus expenses). If you die before the policy expiration, the insurer pays out a full death benefit. If you don’t die before the policy expiration, you get back your premiums plus interest, minus expenses. There are people who strongly believe whole or cash value life insurance is a good investment, but many independent financial writers disagree (see the example below).
Term Life Insurance
Term life insurance is temporary insurance. With a term policy, you pay regular premiums for a fixed term (e.g., 10, 20, or 30 years). If you die within it that term, the insurer pays a death benefit. Otherwise, when the term expires, you do not get any of your premiums back.
Okay, so based on the above descriptions, cash value sounds like the better deal. After all, with cash value you get to keep some of your investment if you don’t die. Why should you go with term life insurance?
For one, compared to investing wisely, on your own, in mutual funds, cash value life insurance makes a mediocre investment. Salespeople promise all sorts of great returns, but after expenses, buying a cash value life insurance policy can be like leaving your money in savings account for 30 years — the returns may (or may not) beat inflation. In addition, term life insurance is substantially more affordable than cash value life insurance. For example, for annual premiums of $500 a healthy 30-year old man might easily get $500,000 in term life insurance, whereas a cash value policy might only pay a death benefit of $50,000 for the same premium.
Dave Ramsey also recommends term life insurance above cash value, citing the following example:
If a 30-year-old man has $100 per month to spend on life insurance and shops the top five cash value companies, he will find he can purchase an average of $125,000 in insurance for his family. The pitch is to get a policy that will build up savings for retirement, which is what a cash value policy does. However, if this same guy purchases 20-year-level term insurance with coverage of $125,000, the cost will be only $7 per month, not $100.
Ramsey goes on to give average returns, after expenses, for whole life (2.6 percent) and universal life (4.2 percent). That doesn’t sound half bad, but a disciplined individual investor should be able to get an average return of between 6 and 12 percent investing over 30 or 40 years.
So the lessons are: If you have a family, you need life insurance (regardless of age) until you have saved enough to provide for them if you die. Do not buy cash value life insurance, get a term policy and invest the difference.