The following post is written by Brian So, an insurance advisor and blogger at http://aafsinsurance.com.
When it comes to life insurance, many of you may have heard of the strategy ‘buy term and invest the difference.’ Before I get into the concept behind the strategy, you should know the basic differences between term and whole life insurance. With term, you purchase temporary insurance that expires at a age 80 or 85, with premium increases at every term renewal, most common being 10 and 20 years. Whole life, on the other hand, has a fixed premium but never expires as long as the insured continues to pay the premium. The premium for term insurance starts out much more manageable, but its price increases exponentially and eventually outpaces whole life.
Whole life insurance also has a cash value that is guaranteed and increases every year. Contrary to popular belief, there is no investment involved with whole life insurance. The cash value is actually a reserve of premium kept on the side by the insurance company due to overpayment of premium in the early years.
Buying term and investing the difference means that you purchase term insurance and invest the difference in premiums between term and whole life. The hope is that when you cancel the policy at age 65, your portfolio will be larger than the cash value in a whole life policy.
For example, let’s consider a 35 year old non-smoking male looking for $500,000 of coverage. His options are a term-30 policy, which would take him to age 65 at renewal, and a whole life policy. The annual premium for the term-30 policy is $750, while the annual premium for the whole life policy is $3,395, for a savings of $2,645. Assuming he invests this amount at the beginning of each year for 30 years with a 6% return, he will have $221,655 when he turns 65. The cash value of the whole life policy at age 65 will equal $131,500.
Clearly, buying term and investing the difference is better than buying whole life and cashing out at a later date. Or is it? Are there other factors that affect the comparison? Let’s take a look at the pros and cons of the strategy.