Life insurance fits 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 term and permanent 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
- You can convert some policies into permanent insurance
Cons
- Premium payments are an expense (builds no equity)
- 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
- Some permanent insurance policies have an investment component built-in, called cash value. Premium payments consist of insurance cost and contributions to this investment component, the cash value
- Cash value grows on a tax-deferred basis as long as the policy remains tax-exempt, which is simple to accomplish
- Cash value can be used in a variety of ways, such as increasing the death benefit, withdrawing for personal use, as collateral for a loan, or providing a stream of retirement income
Cons
- More costly in the early years than term insurance
- Cash value comes with a surrender charge in the early years. This deters 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. With owning a property, you’ll have to pay the mortgage, utilities, strata fees, property taxes, utilities, etc. However, 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 decreases.
Permanent insurance premiums can be looked at like a mortgage payment: some of the premium is going towards the interest (cost of insurance), and the rest is reducing the mortgage and building equity (cash value).