Life insurance is an essential step in protecting your loved ones if the unthinkable happens, but you may have also heard it can double as an investment strategy. When you’re trying to set your family up for financial success, the idea of an investment component can seem inviting.
But while life insurance is important to have, using it as an investment vehicle may not be the best use of your money. We’ll walk you through the ins-and-outs, so you’re armed with the knowledge to make the best choice for your family–and your wallet.
How life insurance works as an investment
When considering life insurance, you generally have two main options, term life insurance or whole life insurance.
Term life insurance is straightforward. It offers your family a fixed payout if you pass away during the policy’s term. The policy term is measured in years, typically 10, 20, or 30 years. Term coverage allows you to save cash on your premiums compared to a whole life insurance policy while offering your loved ones coverage when they need it most — when they’re financially dependent upon you.
Then there’s whole life insurance. With a whole life policy, you pay premiums for your entire life or one large upfront premium for permanent coverage. Because this is a lifetime policy that is designed to cover you into your golden years, premiums are significantly higher than with term life insurance.
That said, whole life insurance offers an investment angle that term life insurance doesn’t. With a whole life policy, part of the payment you make toward the policy goes toward your premiums, and the rest of the payment gets invested. This invested cash goes into a low-risk fund, and your insurer will guarantee the rate of return on the investment.
But while this investment element can seem enticing, there are some considerations to keep in mind.
The drawbacks of life insurance as an investment
While a whole life insurance policy covers your family and builds cash value as an investment vehicle, it’s not exactly a two-for-one deal, and you should consider the drawbacks of this option.
The big downside to using a whole life policy as an investment is it has a higher premium for the same coverage amount a term life insurance policy can offer. Not to mention, if you no longer need the whole life insurance 20 years later, you’re still locked into paying the premiums or letting the policy lapse and losing all the cash value it’s built.
Also, you have no control over the investments made on your behalf. Because the insurer guarantees the rate of return, it’s responsible for choosing the investments. And while there is a guaranteed rate of return, it’s generally around 1.5%, which is dramatically lower than the 10% average return from investing in the stock market directly.
A whole life policy typically only makes sense for high-earners because they can afford the higher premiums and can earn significant tax-free income from its cash value. It may also benefit those wealthy individuals with significant assets to pass on after death by providing death benefits to beneficiaries that they can use to pay estate and inheritance taxes after the policyholder’s passing.
However, most people will not fall into this high-earning category and simply need life insurance to protect their family in case the unthinkable happens. If you fall outside this category, a whole life insurance policy is not worth the drawbacks, especially if the investment component is your main appeal.
Alternatives to using life insurance as an investment
While life insurance can be used as an investment, that’s not what it’s ultimately meant for. How life insurance works is by providing your loved ones a safety net in the event that you’re no longer around to help.
Instead of opting for a whole life policy based on its investment potential, you can opt for a less expensive term life insurance policy for only the amount of time you need it. For example, if you have teen children and want coverage until they are through college, a 10-year term policy may be a good option for you.
Then, instead of paying sky-high premiums for coverage you might not need later, you can simply take the difference of what you would have spent in premiums with a whole life insurance policy and invest it yourself. That way, you can adjust your investment at your discretion to improve your return.
Once you no longer have dependents relying on you financially, you can allow the term policy to expire, then roll your annual premium into your investment strategy and continue watching it grow.
Final thoughts: life insurance isn’t a great investment strategy
A whole life insurance policy may draw your interest with its investment possibility, leaving you thinking you can handle two financial goals in one fell swoop: life insurance and investing. However, with a low rate of return, high premiums, and a lifelong commitment, a whole life insurance policy makes little financial sense for most people.
Instead, the average person is better off if they opt for a more affordable term life insurance policy until they no longer have loved ones financially relying on them. They will save on annual premiums and can invest the savings in the stock market, which offers significantly higher returns.