How (and Why) to Buy Life Insurance
Buying Life Insurance seems to be one of those “I’ve finally grown up, I guess I need life insurance” sorts of decisions you make. It often comes into play when you buy a house, get married, or have children.
As it should.
But getting life insurance simply because you think you might need it, without really understanding how much to get or the options you have is a mistake – one that could cost you now in overbearing and unnecessary premiums, or one that will cost you (or your loved ones) later, when you realize that there wasn’t enough to cover your needs.
Here is a basic guide to get you started:
Term or Permanent?
Think of Term Life Insurance as “temporary” insurance – cheap and cheerful. It is good for a defined Term, the most common term being 10 years. At the end of the term, it automatically renews, but at significantly higher rates. If you were to instead cancel and apply for a new insurance policy at the end of your 10 year term, you could get it at much lower rates than if you renewed – assuming nothing happened to you medically to affect your ability to qualify. Either way, Term insurance will stop renewing around the age of 65.
Permanent Insurance (which takes the form of Whole Life and Universal Life), by contrast, is permanent. It stays with you (as long as the premiums keep getting paid) until you die, no matter how old you are. Some policies will pay out the insured amount if you reach the age of 100 (I guess they figure you deserve to have some fun with the insurance money yourself if you live that long). Permanent Insurance is also much more expensive (at up to eight times the cost), for a few reasons including the addition of investment or dividend components to the policy, along with the assumption of medical risk that the insurance company takes on board in providing a life-long quote.
Reasons to Buy Term Insurance
Since Term Insurance is for temporary needs, use it for amounts of money that would be needed now if you died, but that won’t be issues later. For example, your mortgage will eventually be paid off, and the kids will in due course grow up and their education will be paid for, and the need to provide income until retirement to a non-working (or lower income) spouse will be lessened. These are perfect examples of initially large needs for insurance that will deplete over time, making them ideal for Term coverage.
In fact, you may need $500,000 of term insurance now to cover off your mortgage and anticipated educational needs for the kids, but in 10 years’ time when your policy expires, your mortgage will be smaller, and maybe your kids will be through college. You may still need some term insurance, but can get away with a smaller policy, saving money in the meantime.
Reasons to Buy Permanent Insurance
Permanent Life Insurance (such as Whole Life or Universal Life), is for permanent needs. While this may seem simplistic, it is a fact that tends to escape many. Truth be told, permanent insurance needs are few and far between for many families. It is ideally used to cover off things like anticipated estate taxes which might be crippling, or leaving a legacy for children or charity.
There is also a forced savings investment component to permanent insurance that adds a tax-free benefit: After paying for a permanent insurance policy for a period of time, there will be a cash component to it that has grown and compounded tax-free. If, in retirement for example, you want access to this cash component, you can either make a withdrawal (or cancel the policy and get the cash), or you can borrow against this amount. Withdrawing or canceling the policy will involve paying tax on the growth of your investments, which can be cumbersome. But loans are tax-free; so if you borrow against the policy, you can gain tax-free access to money that has grown tax-free. You won’t have to make loan payments, because the insurance company will accrue the interest owing to the policy, which will continue to grow over time (since you didn’t actually make a withdrawal – you just borrowed against it), and when you die the loan will be paid back in full and any money left over is paid to your beneficiaries. Although there is a slight risk of the insurance company unexpectedly calling in this loan, you can decide if it is an acceptable risk.
How Much Insurance to Buy
This is where things get complicated.
- What is your statement of current and projected assets and liabilities?
- What is your earning capacity in relation to your spouse’s?
- What standard of living do you like to maintain?
- How many kids to you have, and what is your policy on paying for their college education?
- What is your current cash flow?
- What is your anticipated income over the life of your career?
These, and many other questions need to be answered before you can determine the proper amount of insurance for yourself. Some experts will guide you to multiply your gross annual income by six, but I find this to be simplistic and callous for such a serious purchase.
How to Buy Insurance
You can easily get online quotes from a variety of reputable sources, and you can even lodge some applications online, making buying insurance easy and time-efficient. BUT – a lot of undue risk lies with you; risk you won’t be aware of until it’s too late and you realize after that fact that you made ill and uneducated insurance decisions. You may not have properly understood the slight differences in jargon when comparing two apparently identical quotes from different companies. Or (as a lesser of the evils of ignorance), you may end up over-paying for a kind of insurance you don’t need (or for too much insurance), costing you the ability to pay off your debts or invest more money.
Moral of the story: don’t try to buy insurance on your own. It’s not worth it. It will ultimately end up costing you more in time, money, and possibly the ultimate financial security of your family.
Instead, consider using the services of an insurance broker or financial planner. Most brokers and planners will have access to bulk discounted rates from a variety of insurance companies – rates that you may not be privy to if you purchase it directly. They can also shop across the market for the product and rate that is best for you and your circumstances, and they understand how to equalize each insurance company’s unique jargon. Some insurance companies give preferential rates to males in their 40s (for example), but you would be hard-pressed to figure these idiosyncrasies out on your own.
But more importantly, a proper broker or financial planner will take the time to figure out exactly what type of insurance and what amount will be best for you. They will determine the answers to all the questions posed above and more, and after talking with you and learning about your ideals and values, will recommend an insurance policy that is customized to your needs.
I could go on for pages and pages about how to determine and calculate your Life Insurance needs, but it still would not suffice. And anybody who tells you otherwise is short-changing you on one side or the other: you’ll either end up short-changing your cash flow to pay for insurance you don’t need, or you’ll end up short-changing your beneficiaries by leaving them high and dry when they are most in need.
Do not take the selection and purchase of Life Insurance lightly. Find an expert who you trust and let them help you. You will end up saving money in the end, believe me.
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