Whole life insurance, like its name suggests, is designed to provide life insurance coverage over a person’s lifetime. Once the insurance contract goes into effect, the policyholder pays a fixed premium at regular intervals throughout the remainder of their life, or up to age 100 for some policies. The insurance company agrees to pay a death benefit to the policyholder’s beneficiary if the policyholder dies while the contract is in effect.
Besides the insurance benefit, the policy builds up a cash value. As the policyholder gets older, the risk of death increases. Instead of continually raising the premium to account for this, the insurance company keeps the premium fixed. In the early years of the policy, the premium is more than what is needed to cover the insurance. The excess is invested in the company’s general investment portfolio to build up a cash value. In the later years of the policy, when the policyholder is older, the premium is lower than needed to cover the insurance. The difference is made up by the cash value that the policy has built up.
Some policies come with an optional rider that allows you to pay future premiums from the cash value. With these provisions, you pay larger premiums early on, and then stop payments after a certain point; future premiums are paid out of the policy’s cash value.
Many whole life policies also allow you to add an accelerated death benefit rider for little or no cost, which will pay out the majority of your death benefit during your lifetime if you contract a terminal or chronic illness or injury. This would help you pay your expenses for the remainder of your life.
As the policyholder, you can borrow from the cash value as needed. The insurance company may charge a modest interest rate on the loan. You can also surrender the entire policy or part of the policy for cash. Borrowing or surrendering reduces the policy’s cash value and death benefit. Also, if you surrender the policy, the cash proceeds may be taxable if they exceed the premiums that you have paid in to the policy.
The insurance company may also pay out a dividend each year based on the cash value. Although it’s not guaranteed, many reputable insurance companies have been paying dividends reliably for decades.
Also, the insurance company sets the premium based on assumptions of future returns. If interest rates or market returns are lower than expected, the cash value and death benefit may also be lower than projected, or you may be asked to pay additional premiums.
Depending on your situation, whole life policies may not be suitable, and a term life policy may be a better choice. Maybe you’re not going to need life insurance for your entire life. For example, you might only need life insurance until your kids are grown. In that case, a term life policy might more cost effective – the premium is lower since you’re only paying for insurance that you need.
For many people, however, whole life policies can be attractive. Here are a few advantages:
1. Stable and predictable cash value. The cash value of the policy doesn’t change as the stock market rises and falls. Rather, the value is guaranteed and continues to grow, albeit at a faster or slower rate depending on interest rate and market conditions.
2. Access to cash value without penalty. Unlike IRAs and 401(k)’s, you can borrow against your whole life policy without tax or penalty.
3. Potential investment tool. The interest rate charged by the insurance company for loans against your policy may be lower than returns you can get elsewhere. This potentially makes borrowing against your policy a good investment, if prevailing interest rates or market conditions are favorable.
4. Guaranteed insurance for life. If your circumstances do change and you need life insurance again later in life, you can be assured the whole life policy will be there, with a fixed premium. On the other hand, you may or may not be able to get a term life policy at the same premium, depending on your health history.