Life insurance can be split into two categories: term and permanent. Term insurance has a pre-determined end date, such as 10 years, 20 years, or to age 75. For example, a term-10 policy provides life insurance for a period of 10 years. Permanent insurance, on the other hand, never expires (as long as the policy remains paid for, of course).
Let’s look at some of the advantages, and disadvantages, for the two types of life insurance.
Term Insurance
Pros
- Inexpensive (compared to permanent insurance)
- Covers a temporary need, such as a mortgage, children’s post-secondary education, or income replacement for a set number of years
- Some policies can be renewed for an additional term without evidence of insurability
- Some policies can be converted into permanent insurance
Cons
- Premium payments are an expense, with no equity being built
- Will eventually expire, leaving no coverage
- Renewal rates are significantly higher than the premiums during the initial term of the policy
Permanent Insurance
Pros
- Coverage for life, which can cover temporary needs and develop into an estate and tax planning tool
- In the long run, less expensive than term insurance if policy owner was to continually renew their term policy
- Permanent insurance policies have an investment component built-in, called cash values. Premium payments consist of insurance cost and contributions to the cash values
- Cash values grow on a tax-deferred basis as long as the policy remains tax-exempt, which is simple to do
- Cash values can be used in a variety of ways, such as increasing the death benefit, withdrawing for personal use, or as collateral for a loan
Cons
- More costly in the early years than term insurance
- Cash values come with a surrender charge in the early years to deter against unintended tax-advantages
Housing analogy
I will use a housing analogy for a quick and easy way to distinguish the two types of insurance:
- Term insurance is renting – housing payments are an expense
- Permanent insurance is owning – housing payments are a blend of expense and asset-building
When you rent a house, you get access to it for a set amount of time. Rent payments go to the owners of the property – no equity is being built by the renter. The advantage of renting is smaller monthly payments as opposed to owning a property and having to pay the mortgage, utilities, strata fees, property taxes, utilities, etc. Alternatively, when you own a house, you are building equity with each mortgage payment. Mortgage payments are a blend of interest and principal, and those principal payments are gradually building equity in the house as the mortgage amount decreases.
So, which is better?
There is no right or wrong option. At the end of the day, when it comes to life insurance, the main purpose is to have it in force when you truly need it. For some, that is until their children reach a certain age. For others, it is for the entirely of their life, as they want capital to cover funeral expenses and taxes at death. Often times, a blend of the two types of insurance serves as a great strategy, providing cost-effective term insurance to cover temporary needs, and a flexible, tax-advantaged asset in permanent insurance that is building equity and provides coverage for life.