Life Insurance Explained - Term Life Insurance vs. Whole Life Insurance

Insurance is one of those interesting topics because a lot of us either have it, have thought about getting it, or will have to get it at some point in our lives, and there's a lot of different types of insurance out there. Today we're going to focus on one of the most important, misunderstood, and potentially the most predatory type of insurance out there, which is life insurance. Life insurance is something that Dennis and I have talked about many times over the last few years, and we understood how it works in theory and its purpose, but a lot of the stories that you hear and the products that are available just don't seem to make a lot of sense, which isn't that surprising because it's literally an industry that profits off of confusion. We want to make this topic as simple as possible for you, and we're going to explain what life insurance is, what type or types might be useful for you, and also in general how an insurance policy works and what to look out for. To kick things off, we need to break down what life insurance is meant to be at the most basic level. Life insurance is something that's meant to give you peace of mind by ensuring that your family will have money if anything ever were to happen to you. It's a contract between an insurance company and you where you pay monthly fees, which are called premiums, and then if you die, they agree to pay out a death benefit, which is a big chunk of money, to your family, who are the beneficiaries. It's kind of similar to car insurance, which you're probably familiar with. You pay a monthly fee, and you aren't getting anything in return right away, or potentially ever. But in the future, they're essentially promising to help you out financially by covering the cost of repairing damage to your car if you were to get in an accident. With life insurance, it's the same thing, except it covers your family being able to pay off your mortgage, pay any outstanding taxes, and just keep the family going financially if you were to die. If you have anyone in your life, either a spouse, children, or even your parents, who depend on your ability to bring home an income, those would be your dependents, then it's possible that you might want to consider getting a life insurance policy. Now, there's a few different types of life insurance out there, mainly temporary or term life insurance, and permanent or whole life insurance. And there's a lot of different phrases that people like to use when they're talking about life insurance, like term, whole life, universal life, variable life, infinite banking, be your own bank, there's also the rich man's Roth IRA in the United States. Basically, there's just a lot of different terminology out there, but what's important for you to know is that all those different terms either fall under temporary or permanent life insurance. Now, if you hear the word term, that means temporary, but if you hear anything else that you don't understand, or anything that sounds kind of like a gimmick, or anyone that's talking about coverage for your entire life, that would be most likely permanent life insurance. Here's how term life insurance works. The idea is very simple. Term life insurance covers you for a very specific period of time that you choose when you're purchasing the policy. Now, it can range from anywhere from five years to 40 years, with 10 to 20 year terms being the most common terms that people usually select. So once you select your term, if you die during that period of time, the policy will pay out your beneficiary, so once again, this is your family, the amount of money that was stated in the policy. The amount could be $500,000, it could be a million dollars, or whatever amount you decided you needed, but what you have to remember is that the higher the payout, usually the higher the monthly fee, or in other words, the premium will be. On the other hand, if you don't die during that time period, then no money is going to be paid out. Term life insurance typically costs much less than permanent life insurance, because if you think about it, whole life insurance is, well, for life, so you're going to get paid out something at some point, making it more expensive, but we'll get back to whole life insurance in a second. Now, when I say the term life insurance costs less, I'm referring to the monthly premium, so for example, let's say we have a healthy 28 year old with dependents, so let's say they have a wife and two kids. The quote for a 20 year policy with a death benefit, so aka the payout that you're going to get, of $500,000 would be somewhere around $30 a month. Now, if they wanted a whole life policy instead with the exact same scenario and the exact same death benefit payout, the quote for that policy would be somewhere around $250 a month for life. That's $7,200 versus $60,000 in payments over 20 years, and not to mention the fact that the payments wouldn't stop after 20 years for the whole life policy. Now, when you're looking at those numbers, you might be thinking that going with a term life policy makes sense for a number of reasons. Obviously, it's lower cost, but also in that situation that I was describing or scenario that I was describing earlier with the guy who was 28 with two kids and a wife, after 20 years, the kids are likely going to be grown up and not dependent on him anymore, and then depending on their financial situation, a good chunk of that mortgage might also be paid off too. But here's where people trying to sell you whole life insurance slide in, and they try to make it make sense. Let me explain. When it comes to the likelihood of you dying, the statistical likelihood, that number increases the older you get. Think about it. The older and older you're getting, the more likely you're going to die. If we show you this graph, it's actually really interesting because you can see that at a certain point, it starts to go up exponentially because once you hit a certain age, the odds grow much more quickly. Not surprising. Now, if you compare the likelihood of dying graph with the cost of insurance premiums you can see that they're almost the exact same. Basically what happens is that the younger you are, the insurance premiums are actually going up slower, but the older you get, the more quickly they start to go up. So what someone who wants to sell you on whole life insurance might say is, what happens if you need insurance after that 20 year period once you're older? The cost is much higher, and for a lot of insurance companies, they don't even offer term life insurance after age 79. So when you're looking at the numbers for even term life insurance, they just become overly expensive to the point where they're even thousands of thousands of dollars a month just later on in life. At that point, you might start to think, well, maybe I should just get a whole life policy because it's going to cost less later in life. But hold on. Let's talk a little bit more about that. Now let's get into what whole or permanent life insurance actually is. Permanent life insurance policies cover you for life. So instead of covering you for a specific period of time, they cover you from when you sign up for the policy until you die, assuming that you pay your premiums. Now, I say that because missing multiple payments can actually cause you to no longer have your policy in place anymore, and you'd have to then take several necessary steps to get back on track. Typically, if you just miss one payment, it's not as big of a deal because there's a short grace period, but it becomes a bigger deal and is not ideal once you miss multiple payments. Whole life is the most well-known type of permanent life insurance, and the biggest difference between term policies and whole life policies is that whole life policies actually have two components. One is the death benefit, which is that money that your family would get if you were to die. And then the second part is the cash value portion, which I'm going to explain. Remember how we said that term policies have a cheaper premium, so monthly costs than whole life policies? Well, what insurance companies will do with whole life policies is they'll put a portion of that higher premium aside into an account that either earns interest or they'll invest it on your behalf. Basically, what I'm saying is that with whole life policies, they combine the death benefit, which is the main reason that you'd be signing up for life insurance, with investing, so Now for a lot of people, that sounds amazing because you're being told that you get life insurance coverage for life, and on top of that, you don't have to worry about saving or investing everything for the future. Everything's covered for you with this one product. But here's the thing, and we talk about this on our channel all the time, it's usually not actually ideal or beneficial to go with one product or even one financial institution for everything. We're going to talk more about this in a second, so don't go anywhere. But first, back to the cost for a second. With whole life insurance, you're paying a relatively static premium for a very long period of time. At first, you're overpaying, so you're paying a very high fee, but then later on, you end up underpaying because you signed up when you were younger. If we go back to our graph from earlier, you'll notice that when you get to an older age, the premium could have cost a lot more, but in this case, you'd still be paying the lower premium from when you signed up. Also, remember that we're saying lower here, but it's still much higher long term than term life premiums. Again, this sounds great in an isolated bubble, but when we zoom out, you have to remember that it might not even make sense for you to have life insurance for life. But all of a sudden, you get caught up in the idea that you're getting a deal by signing up at a young age, but you aren't actually saving any money at all if it's not a product that you should be getting. I also want to get back to the reality of mixing two different products, so an insurance product and an investment product. A lot of the time, people are under the impression that you have two positive things happening from the same premium that you're paying. When you die, your family, your dependents, they'll get that death benefit, and at the same time, your investments, or the cash value, is growing so that you can eventually use it for your retirement spending or also to pass on to your loved ones. But that's not how it works. You actually don't get to keep both the death benefit and the cash value. You only get to keep one or the other. The cash value is money that you can withdraw from or borrow from the policy while you're alive. It's made up of the premiums that you've been paying minus the cost through the insurance, so the fees or any other charges that the insurance company is taking out of that money that you've been putting in, and then your cash value grows by this company investing that money for you. Now, at first, the cash value will be lower than the amount of money that you're putting in regardless of how the investments are performing because they're withdrawing all of those fees, right? So to give you a very high-level, very simple example, if you're putting in $200 and they're taking out $150 to put towards fees, then you'd only have a cash value of $50 for now. If you decided that you wanted to leave the policy and move on, you would lose $150 and then you'd only have that cash value of $50 to get back. And eventually, it could be in three years or in 15 years, depending on a number of different factors, the cash value will match and then surpass the amount of money that you paid in premiums for this product. So when Steph said you don't get to keep both the death benefit and the cash value, you only get one or the other, here's what that means. If you keep your policy for life, so until you die, your dependents should get your death benefit. If you ever terminate your policy, you are no longer entitled to your death benefit and instead you'll receive the cash surrender value. This is basically your current cash value minus any fees that they charge for you having to surrender your policy, which by the way, would actually happen to be a lot of money. You can also take money out of or borrow against your cash value throughout your life, but you have to remember that this will decrease the amount of death benefit that you're entitled to. And once again, you can only have one or the other. Now, if you die and your dependents get paid out your death benefit, no matter how much your cash value is currently sitting at, they are not entitled to that money. They can only collect the death benefit. Now your cash value on the other hand, that goes back to the insurance company. So if you think about it, they're basically profiting off of your money and your investments. The biggest thing we want to mention here is that this just simply isn't a good product for the vast majority of people. Like there are so many other different places that you could put your money that are so much better. You can literally put the same amount of money that you're paying into these whole life insurance premiums into a different investment product with less fees and the potential for higher returns. When you really look into it, a lot of these whole life insurance products don't have the best returns because the company's honestly just more focused on making money now and their own investments than they are maximizing your investments to their fullest extent. If you did this, you'd make more money while you're alive, maybe to use for retirement and to leave to your family independence if and when you die. And then aside from investing, if you still want life insurance, you could buy a term life insurance policy that's cheaper and it's not trying to invest your money on top of that. You're basically getting what you paid for. What a concept. Again, this isn't financial advice, but this is what we believe is most useful for the vast majority of people. Now, if you're watching this right now and you've already purchased a whole life insurance policy and you're wondering whether or not you should cancel it, of course it depends. But especially if you're young and you just recently purchased a policy, you might want to consider letting go of it. When we were doing our research on life insurance, specifically whole life insurance, we found that it typically takes 10 to 15 years to build up a good amount of cash value, which is basically defined as enough money. So a large enough amount of money for you to borrow against. But honestly, at that point, you could have already gone ahead and invested your money yourself, likely earning more money and in a more clear way. And basically what I mean by that is that, you know, you'll actually have transparency around the fees. I feel like the sun costs fallacy. So when people start to think that because they've already put their money into something and they don't want to pull it out, despite the fact that leaving it in there will probably lose them even more money, I feel like this is where that starts to come into play. When people buy whole life insurance or any other bad financial product, they have a really hard time getting out of it and losing some money and just leaving, despite the fact that staying in it is likely going to result in them losing even more money long term. Also in general, there's no magic product out there that provides multiple things at the level required to have success in all of them. We say the same thing about banks and financial platforms when it comes to having the best checking, saving or even investment accounts. Usually you'll want to have multiple different ones. The last thing we want to address in this video is how much life insurance you should buy if you do decide that you need it. And again, we're ideally talking about term life insurance here. When it comes to insurance coverage, it's going to depend on your personal situation. Some people need more coverage and some people need less coverage. Now for some people, they might need or want coverage for things like funeral costs or for minor estate taxes. For other people, they might have beneficiaries who rely very heavily on their income and therefore they're going to need more coverage for if and when they die to make up for the loss of that income. In Canada, about two-thirds of households have life insurance and of the people that do have life insurance, the average death benefit amount is about $200,000, which is said to be less than what most people need. We've also heard that the recommended amount is 10 times your annual net income, but again the ideal amount for you might be more or less than the standard amount. So one method that you can use is called the DIME method. It stands for Debt, Income, Mortgage, and Education Expenses. And basically all you have to do is just add all of those amounts together. That means that you'd add up any outstanding debt that you have plus your annual net income multiplied by the number of years that you think your family will be relying on it, plus the outstanding amount that you have left on your mortgage, plus an estimate for your kid's education costs. Then you'll need to adjust this amount based on the level of premium that you can afford to pay for, but this is a really good starting point so that you're not going into it completely blindly. The golden rule is to buy what you need, make sure it's renewable so you have the option to renew at the end of your term, and also invest your own money on the side for yourself. No one knows what's going to happen in the future, but if you can make a plan for you and your dependents that doesn't involve giving unnecessary amounts of money to an insurance company, that's ideal. There is so much to cover when it comes to life insurance, but we really hope that this was a helpful starting point. If you have any questions or comments, make sure you ask them away down in the comment box below, and remember to subscribe to our channel because we'll be back next week with another video.