The main difference between term life insurance and whole life insurance is that term life insurance serves as insurance only, whereas whole life insurance is actually insurance plus investment.
A term life insurance policy has 3 main components - face amount (protection or death benefit), premium to be paid (cost to the insured), and length of coverage (term). The policy expires at the end of the term. If the insured person dies during the term of the policy, the beneficiary is paid the benefit (face) amount. If the insured person is alive after the term (duration) of the policy, no benefit is paid and the policy expires. So in a sense, it is like car insurance, where if you have a six-month policy and you get into an accident during this period, you get compensation from the insurance company. But at the end of the period if no accidents happen, you do not get any money back.
Whole life insurance on the other hand is a form of permanent life insurance, which means that in addition to insurance, the policy also has a savings component. A part of the premiums paid by the insured person goes towards insurance, while the remainder is invested and builds a "cash value". If the insured lives beyond the policy expiration, the cash value is paid out to the insured. The cash value can also be used to borrow money against. The cash value is invested (in bonds and stocks or money-market instruments), and therefore there is a gain. This gain is tax-deferred if the policy is cashed in during the life of the insured. (If the insured person dies, the proceeds are usually tax-free to the beneficiary.)
edit Cost of a Term vs. Whole Life Insurance Policy
Whole life insurance policies are a lot more expensive than term policies. Moreover, often there are hidden costs in whole life insurance policies such as:
- high fees and commissions that can lop off as much as 3 percentage points from the annual return (APY).
- up-front (but hidden) commissions that are typically 100% of the first year's premium. It's often impossible to tell what the return on the investment will be, and how much of what you pay in goes toward the insurance and how much toward the investment.
edit How to Choose
These are some of the factors to consider when choosing between a term life or whole life insurance policy:
- Term life insurance is a lot cheaper than whole life insurance, and therefore premiums for term life insurance are much more affordable. The money saved can be invested in other investment options.
- If you are over 65 or 50, it may be a lot more difficult to get a term life insurance policy in the US.
- The choice between term and whole life is typically clearer in certain situations. If you need insurance for a term of less than 10 years, term life insurance works out to be clearly more cost effective. For a term over 20 years, whole life insurance tends to be more cost effective.
Suze Orman vehemently advises a viewer against whole life insurance. Find out why: