With all sorts of costs and priorities in your monthly budget, the idea of life insurance may feel like an unnecessary expense. Especially for the young and healthy, life insurance might occupy a lower place on their list of personal finance priorities. So, should you consider buying life insurance?
There are a number of reasons to purchase life insurance, but it is not right for everyone. Prior to making a decision on whether or not life insurance fits with your financial roadmap, it is important to understand the ins and outs of this financial arrangement.
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What Is Life Insurance?
In essence, life insurance is a contract between you and an insurance broker. In the event of your death, the broker will pay a death benefit to the beneficiaries you’ve designated in the agreement.
Though the details vary by plan and provider, there are essentially two different types of life insurance policies: term life insurance and whole life insurance.
Term life insurance: Term life insurance is a contract for a set period of time, which usually comes in batches of round numbers such as 10-, 20-, or 30-year timeframes. In exchange for regular premium payments, the insurance provider will agree to pay a death benefit if the policy holder dies during the agreed-upon term. Because it expires, it is a cheaper option than whole life insurance.
Whole life insurance: Whole life insurance is a contract for the entirety of your life. Assuming you remain current with your premium payments, it never expires and provides a guaranteed death benefit for when you ultimately pass away. Whole life insurance also contains a “cash value,” which grows at a fixed, pre-determined rate throughout your ownership of the policy.
The “cash value” gives whole life insurance plans an inherent value, which you can redeem or even borrow money from while you are still alive — though if you do so, this will either decrease or remove any death benefit that would go towards your beneficiaries. It is, therefore, a much more expensive type of policy than term life insurance.
Who Benefits from Life Insurance?
The benefits of life insurance are fairly straightforward. If you die while your plan is in force, your beneficiaries will receive a death payment.
These funds can be used for both immediate needs and longer-term horizons and will help your family once you are gone. The size of the death payment that your beneficiaries will receive depends on the contours of your specific plan. As a general rule, the higher your premium, the greater your eventual death payment.
The benefits can serve different purposes, depending on the type of life insurance that you choose.
For those with term life insurance, especially those who are earning a salary, the payment will help with the cost of supporting families and future obligations. One common method for calculating the amount of the desired death payment is the DIME approach, which takes current and future Debts, Income, Mortgage, and Education expenses into account.
According to DIME, you will design your death payment by adding your existing debts, your current salary, and an estimate for how long your dependents will need this income, your remaining mortgage obligations, and expected future education costs for your dependents. As morbid as it sounds, this will help your family transition to their new lives after your death.
Whole life insurance is also meant to help your family members, though it is less geared towards those hoping to help their children become settled or pay off an existing mortgage obligation. Because whole life insurance never expires, it can be an appropriate financial tool for those with a lifelong dependent–such as a disabled child–who will always need care.
The cash value portion of whole life insurance grows without tax obligation, so it can be useful for high-net-worth individuals who have maxed out their annual contributions to their 401(k) plans and IRAs.
In addition, due to the cash value component of whole life insurance, the holders have the option of taking money out of the policy while they are still alive. Owners can also decide to end their policy, which is known as surrendering their coverage. When this happens, you will receive the cash value you have accumulated (minus any fees your provider charges). However, your beneficiaries will no longer receive a death benefit.
Is Life Insurance Right for You?
Life insurance–like every other type of insurance–exists to provide coverage when bad things happen. In this case, this event is your eventual death.
For many individuals, especially those with young families, term insurance is a smart financial decision. Having this more limited insurance can give you peace of mind that your family will be taken care of if you are not longer here to provide for them. Because they eventually expire, they can be an economical alternative.
Whole life insurance is a more complicated financial instrument, and generally only makes sense for those with higher incomes who can afford the more expensive monthly premiums.
At the end of the day, the decision to purchase life insurance comes down to striking the right balance between current costs and future obligations. While paying for insurance premiums can stretch tight monthly budgets, the real question to ask is what your dependents will need once you are gone. If you are in the financial position to take action now to protect them later, life insurance is a smart long-term play.
Conclusion: Once and Future Costs
Every personal finance decision comes down to balancing multiple priorities. While most line items on your budget consist of navigating the tension between current consumption versus future savings and investments, life insurance constitutes a slightly different type of consideration.
It is a financial determination that is explicitly dedicated to caring for your loved ones after you are gone. Therefore, the decision to purchase a life insurance policy comes down to a simple equation: what can you afford to pay now in order to help your family later?
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