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Types of Life Insurance: Which is Right for You?

If you have a car, you have car insurance. If you have a home, you have homeowners insurance. If you have a life . . . well, it only makes sense to carry life insurance, right?

Life insurance is one of the most vital pieces of your family’s long-term financial plan—and it’s the one we want to discuss the least. Its purpose is simple: to replace your income for your family if you die. But with all the choices available, finding a policy that’s just right for you could lead to extreme confusion and frustration.

Fortunately, it doesn’t have to be that way. We’ll take you through the most common life insurance policies and help you find the one you need.

Here’s a list of different types of life insurance:

Different Types of Life Insurance

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Common Types of Life Insurance Policies Explained

Term Life Insurance

Term life insurance is the simplest (and usually the most affordable) type of life insurance you can buy. That’s because it’s insurance that does one thing and one thing only: pays the people you choose—your spouse, children or other beneficiaries—a fixed amount of money if you die.

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But a term life policy is not worth a thing unless you die during the course of the term. (We said it wasn’t a fun thing to talk about.) The bottom line is, it’s a way for you to proactively take care of your loved ones so they don’t have to worry when you’re gone.

Think of it like your car insurance. Every six months (or maybe every month), you pay your insurance company. If you have a wreck, they pay the claim. But if you don’t have a wreck? You don’t expect a refund on your premiums just because you didn’t get in an accident.

With term life, you’re paying the insurance company to assume the financial risk of your death during the period (or term) of your policy. Typical terms are 10, 15, 20 or 30 years. So, if you buy a 15-year term life policy with $500,000 in coverage, you’ll make a monthly payment for 15 years. If you die during that 15 years, the insurance company will write your family a check for $500,000, also known as the death benefit.

If you’ve listened to Dave Ramsey for more than five minutes, you’ve probably heard him say term life is the only life insurance policy you should get. We recommend you purchase a term life insurance policy worth 10–12 times your annual income. That way, your income will be replaced if something happens to you. This is the cheapest way to protect your family long term. More on that later.

Permanent Life Insurance

There are two main kinds of life insurance (with a few other varieties we’ll deal with later). But the basic types are term life (which, like we just said, is the best and cheapest way to get life insurance) and permanent life insurance. Even though all the different forms of permanent life insurance are way more expensive and confusing than term life, that doesn’t mean they’re not popular. We believe that’s because many people just lack the info about these rip-offs. Let’s talk through the types of permanent life insurance!

types of life insurance

Types of Permanent Life Insurance

Whole Life Insurance

 

Whole life insurance is one of the most common examples of permanent life insurance, and since it’s such a widespread form of rip-off—errr, policy—we’re going to deal with it right out front to try to steer you away from it.

If term life is pretty easy to understand, permanent life policies like whole life is where it gets really complicated. That’s in part because it’s a financial product trying to do two things at once. It’s trying to provide the benefits of life insurance—paying your beneficiaries in the event of your death—and trying to be an investment account at the same time.

When you purchase a whole life policy, you lock in the premium amount for as long as you want the policy. Sounds good, right? And each month when you pay your premium to the insurance company, a portion of that premium goes into a cash value account that grows during the whole life of the policy. Get it? Whole life?

The longer you own the policy, the more cash value it has. It really is like a savings account. So why don’t we recommend this approach to life insurance? Because your life insurance has one job: to pay your beneficiaries if you die. Whole life does this and grows a cash value, so you’re usually paying more for less insurance.

That’s why whole life insurance can be a lot more expensive than term life insurance. Worse still, whole life policies don’t gain as much cash value as that extra amount you’re paying would if it were invested in a good mutual fund. Does it make sense to spend more money for less coverage and a bad long-term investment? (Hint: It doesn’t.)

In addition to whole life, there are quite a few other types of permanent life insurance. What all of these policies share is some form of the feature we already mentioned: cash value. Think of cash value as a savings account you’re depositing money into every month. It’s a pool of money you own and can access or borrow against. The longer you have the policy, the more cash value the policy has.

Another major difference between term life policies (which we recommend) and permanent life policies (which we don’t) is that permanent policies don’t expire. They continue until you die or quit paying your premium.

The particulars of how much your family receives, how the cash value grows, and other questions depend a lot on the policy you purchase. So beyond whole life, permanent life insurance policies can also include universal life, indexed universal life, or variable universal life.

Universal Life Insurance

Like a whole life policy, universal life insurance has a death benefit and a cash value. But unlike whole life policies, universal life insurance policies offer adjustable premiums—meaning you might be able to access some of the cash value to adjust your yearly payment.

Either way, you’re not off the hook for the minimum premium payment to maintain the policy. But you might be able to eliminate a premium payment depending on how much potential cash value you have. Or you might choose to leave things alone and possibly rack up some cash value over time.

Which leads us to the long-term investment “strategy” of this type of policy. Basically, part of the monthly premium of a universal life policy goes toward the death benefit and another part is invested as “savings.” The thought is that the investment will grow with time—and maybe even enough to offset the premiums altogether.

But in reality, this is a bad investment strategy. Why? Two things:

  1. Fees: Beware of management charges. They’re real and they’re hefty.
  2. Annual Renewal Term: Prepare to have smaller portions of your premium annually “renewed” or applied to the cash value investment part of your policy, and then larger portions annually “renewed” or applied to the insurance portion of your policy.

An annual renewal term might help cover the increased risk of death as you get older, but that will be the only thing increasing—definitely not your savings! You’re better off getting a term life policy and investing in a mutual fund for a better return.

Variable Universal Life Insurance

Remember how whole life and universal life policies are trying to do too many things at once? So are variable universal life policies. They just get more complicated! Variable universal life policies are trying to be a life insurance policy, a savings account, and a mutual fund all at one time. And that gets expensive.

Variable universal life insurance allows you to decide how your cash value is invested. As with a traditional mutual fund, there are dozens of risk levels you can choose. You’re presented with a host of investment options for your cash value, and you get to pick how risky you are with those investments. That’s the “variable” part. However, it’s key to remember that insurance is about risk and who assumes the risk.

Because you are in control of where your money is invested, you bear the risk of your investments—not the insurance company. Variable universal life policies have no guarantees about how much the cash value of those policies will be.

Dave considers variable universal life policies to be one of the worst life insurance options on the market because of the high management fees. (Are you seeing a fee trend here?) Again, you would be much better off getting a term life policy and putting your hard-earned money in mutual fund investments.

Indexed Universal Life

Are you ready for yet another confusing life insurance product that jams in investment options? Well, let us introduce you to indexed universal life (IUL)! Let’s see how this one works—or more accurately, how it fails.

We all know and love the stock market, right? You’ve likely heard of indexes like the Dow Jones Industrial Average, the S&P 500 and Nasdaq. Each of those is an index that measures how well the market (or a defined portion of the market) is doing. Index funds are mutual funds that invest in the companies included on these indexes.

So, you can invest in an index fund that mirrors the S&P 500, for example. Some investors like to use them as a safe but passive form of investing that typically leads to average returns on their investment.

How does that tie in with an IUL? Here’s how. For anyone with an indexed universal life insurance plan, there’s both a cash value portion and a life insurance portion with a death benefit. The cash value portion is invested in an index fund.

Now, if the market does well, the cash value will go up. Great! But there is a catch—the rate will always be a little lower than the performance of the index fund because the insurance company will take their hefty share. Yeah, once again with permanent life insurance, fees bite you hard where it really hurts.

And if the market isn’t doing well? You’ll be shocked to learn the cash value portion of your IUL policy will drop too. And this commotion in markets means sometimes you could pay way more for your premiums, and other times, you could pay less.

Other Types of Life Insurance Policies

The two primary types of life insurance—term life and permanent life—are just the tip of the iceberg. Insurance companies also offer dozens of other insurance policies, each designed to pay death benefits in different ways. Here’s a brief overview of the other types of life insurance you may encounter when you’re shopping around.

No Medical Exam Insurance

Applying for either a term or whole life policy in the past was kind of like trying out for a sports team—you had to get a complete medical screening just to get started! We’re talking blood draw, body weight and drug screening! But due to recent market changes, no medical exam policies and touchless exams have become the norm. Top-shelf companies now offer this approach at the same rates as options that require a medical exam. There are two sub-types of life insurance without a medical exam:

  • Simplified Issue Life Insurance: These policies don’t require a medical exam, but they do require applicants to answer a health questionnaire.
  • Guaranteed Issue Life Insurance: Guaranteed issue has even fewer strings attached than the simplified policy—you don’t even have to answer any questions about your health! Many companies limit this type of coverage to people who are at least 40 years old, and some companies don’t offer it to those over 80. But if you’re in that wide range, you’re probably gonna qualify. One drawback here is that your policy will be under what’s known as a graded death benefit. In other words, if you as the policyholder pass away within the first few years of buying, your beneficiaries would receive only a defined portion of the full death benefit. This type of policy allows those who’ve been declined for other kinds of life insurance due to health issues to get enough life insurance to cover final expenses after death.

Joint Life (First-to-Die) Insurance

Joint life insurance, also called first-to-die insurance (yikes!), is a cash value policy marketed to couples who want to share a policy between them. Think of joint life insurance policies as the joint checking account of the life insurance world. The policy covers two individuals for one fee. These policies pay a death benefit as soon as the first spouse dies.

And there’s the problem: If your finances are like most families, one spouse makes more than the other—and sometimes a lot more. Remember, the job of life insurance is to replace someone’s income in the event of their death. Joint life insurance takes a one-size-fits-all approach and pays out the same benefit to either spouse.

That means you could be paying a lot more to insure your spouse’s part-time income from the local fabric store than you would if you were to simply buy two term life policies. A joint life policy doesn’t make a whole lot of sense when you weigh the costs.

Survivorship (Second-to-Die) Life Insurance

If joint life insurance policies don’t make much sense, then survivorship or second-to-die life insurance policies are a complete waste of your money (and doubly hard to talk about). We recommend you avoid survivorship life policies altogether because a survivorship life policy, which is also a type of cash value policy, pays absolutely zero benefit to anyone until both spouses die. Then, it pays your kids.

Survivorship policies are primarily geared toward wealthy people wanting to avoid large estate taxes on what they leave behind. They aren’t really intended to cover your spouse at all. Plus, your spouse isn’t covered when you die. So yes, you guessed it. As with all cash value policies, here’s the broken-record message: You and your spouse are better off getting a term life policy and then investing in a good mutual fund instead.

Final Expense Insurance

At first glance, final expense insurance (or burial insurance) seems to make sense because it’s relatively cheap. Flashy advertisements will suggest you’re sparing your family the burden of paying for your funeral. It’s all about “peace of mind” in knowing your funeral expenses are covered before you die, right?

But burial insurance, which is also a type of cash value insurance, is a completely emotional purchase that makes absolutely no sense financially. Your funeral is something you can plan to pay for if you simply set aside $50 a month every month starting at age 55.

Let’s say you live to the ripe age of 77 years old (the average lifespan in America).1 That’s 22 years of socking away $50 a month or more than $13,000—and that’s assuming you don’t invest the money! If you invest it with your other savings and earn just 10% a year, you’ll have saved almost $50,000! Since the median cost of a funeral is around $7,000, why not just save up the money to pay for your own funeral and tell the insurance company to take a hike?2

Decreasing Term Life: Mortgage Life and Credit Life Insurance

Decreasing term life insurance works like this: As you pay your debts down, your death benefit goes down too. Specific examples of this type of insurance include mortgage life and credit life insurance. In these examples, the death benefit is designed to follow the amortization schedule of a mortgage or other personal loan.

The policies are advertised as a way to settle debts or pay off your mortgage if you die. So really, it’s just making payments on your debts—and your beneficiaries don’t get the full benefits of life insurance. In other words, they potentially inherit nothing more than a paid-off or paid-down debt, but no cash in their pocket. Like term life insurance, there is no cash value. Therefore, the final value is zero at the end of the term.

So, let’s go back and take a look at that $500,000 term life policy example we mentioned above and apply it to real life. If you had a decreasing term life policy and died in the last month of the term, your family would get zero dollars. But if you had a regular term life policy, they would get $500,000.

So, here’s the question: If life insurance is about protecting your family’s long-term financial plan, how on earth can you plan for something you don’t know the value of? That’s the problem with decreasing term life policies. You never know how much they’re going to be worth when you die, so they provide your family very little financial security.

Accidental Death and Dismemberment Insurance

An accidental death and dismemberment policy, or AD&D, is one of those policies almost everyone has encountered at some point. The insurance agent tries to sell you an inexpensive policy that pays out in the event of your accidental death or dismemberment. If you lose an arm and can’t work, it pays a portion of the benefit. If you die in an accident, it pays the full death benefit.

These policies are cheap—usually just a few bucks a paycheck—but you get what you pay for. Many AD&D policies will not pay a death benefit if you die from a medical procedure, a health-related issue or a drug overdose. And as you get older, your chances of dying by accident are significantly reduced. That’s why an AD&D policy is no substitute for—wait for it—a term life policy.

Group Life Insurance

Finally, there is group life insurance. This type of life insurance is bought by an organization or company—which explains the name “group”—and then offered as a benefit to its employees.

The best news if you’ve opted in for this at work is that it’s usually free. It’s also another way to get life insurance without having to take a medical exam. But that’s where the advantages end.

Unfortunately, the death benefit from basic group life insurance is nothing big. That’s because these plans typically only cover a few times your salary. Remember, we always recommend getting a life insurance policy that provides a benefit that’s 10–12 times your annual income.

What Type of Life Insurance Should I Get?

In a word (or two): term life! It’s the only way to go if you want to be smart, save money, and truly provide yourself and those you love with long-term peace of mind.

Here’s why we love term life insurance. As we said at the top:

  • It’s usually the lowest-cost type of life insurance you can buy.
  • It does the one thing life insurance is supposed to do: replace your income when you’re gone.
  • It’s a proactive way to take care of those you love today, so they don’t have a financial burden after you pass.

But how much life insurance should you carry?

We recommend carrying a term life insurance policy that covers 10 to 12 times your annual, pretax income. If you make $40,000, you should carry at least $400,000 in coverage. Why this much?

If your surviving spouse invests that $400,000 in a good mutual fund with an average 10–12% return, they could peel off $40,000 a year from that investment to replace your income without ever cutting into the original investment amount.

Keeping It Simple: Term Life Insurance Makes Sense

Life insurance should be simple. That’s why we recommend only purchasing a term life insurance policy. It’s straightforward, inexpensive and designed to do one thing over the long term: support your loved ones if you die. And as an added bonus, the death benefits of a term life insurance policy are almost always tax-free.

No one wants to talk about it, but we have to. You need life insurance. When you’re gone, those you love will be grieving. This is unavoidable. Leaving them penniless, however, is avoidable. Make sure they’ll be financially secure no matter what.

Whether you’re in the market for a new life insurance policy or just wondering if you’re carrying the right kind of life insurance, we recommend RamseyTrusted provider Zander Insurance. Their insurance professionals will walk you through the process of securing a term life policy that fits your family’s needs. Start here to get your term life insurance quotes.

 

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