Sunday, November 29th, 2015

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A Financial Peripheral: Life Insurance

This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.

Just when you thought your life was getting easier, and now we start talking about insurance. It seems like every time you find a few dollars in your budget I come in and take it away. So what do you need to insure and how much should you spend? The one thing you’ll notice is that the more you own, the more you end up paying in insurance. If you have a $30,000 car you will pay more for insurance than a $10,000 car. Insurance on a $300,000 home is more than on a $100,000 home.

That’s the irony of spending. It costs more to insure more when you buy more. So what happens to that $300,000 home if a fire damages it and you do not have any, or enough, insurance on it? You are stuck with a mortgage payment and no home to show for it. Generally, if you have a loan, such as for a house or car, your lender requires you to have the proper amount of insurance to cover their interests. They don’t want you to just default on the loan if something happens to it.

Understand the Basics of Insurance Coverage

Insurance is a way of protecting you against large losses in the event your property gets lost, stolen, damaged or destroyed or you experience an illness or injury or if you are accidentally the cause of any of the above. That description covers most insurance.

If you understand that insurance is really a way of protecting you against large losses, you will be able to make better decisions on what type of policies to buy. Unfortunately, we have become spoiled over the years and we want everything to be covered by our insurance, with little deductible, if any at all. There is nothing morally wrong with this preference; it just costs us too much. Look at the difference on the premiums for your auto insurance based on a $100 deductible and a $500 deductible. You would have to get in an accident almost every other year to justify the difference.

Remember, when you follow the overall financial principles outlined in this book, you would be getting out of debt (if not already) and putting money back for emergencies and long-term desires. In doing so, you would not need a $100 deductible, because you would be able to handle at least a $500 deductible, if not more. By doing that, you will be able to save money on your insurance, allowing you to put more back for emergencies and long-term savings, which will allow you to increase your deductibles even more, etc. It is like an endless cycle of positive financial returns.

Life Insurance

How much life insurance should you purchase? It depends on your situation. If you are single and you own no real property, you don’t need much life insurance, if any at all. The only reason to buy it now is in case you feel you may become uninsurable at a later date (contracting an illness or something similar). The main reason to purchase life insurance is to protect your loved ones… those who depend on your income… so they can continue on financially without you. For instance, if you are married and you own a home together, you would want your spouse to be able to continue living in your home even though your income is gone. If you have children, then you would want your spouse to be able to keep the house and also provide for your children’s future (such as college expenses, etc.).

Even if you are not working, but are the primary caregiver to the children, will your spouse be able to stay home and care for the kids? Can your spouse afford to pay for someone else to care for your kids while he or she goes to work? These are issues you must consider when buying life insurance. The general rule of thumb says you will need between seven and ten times your annual income. So if you make $50,000 per year, your surviving dependents will need between $300,000 and $500,000 from your life insurance policy. Of course without children you can lean towards six times your salary (even less if you are not married). The more children you have, the more you should lean towards ten times your salary (think about the rising costs associated with college).

Life insurance comes in many shapes and flavors, but it essentially boils down to two concepts: Whole-life and Term. Whole-life insurance covers you for your whole life (as long as you keep making your payments). There are dozens of varieties of whole-life as the insurance industry tries to repackage this concept to make it more attractive. The whole-life concept is usually tied to some type of investment that goes along with your policy. For instance, you would make a monthly payment for your insurance. A portion of the payment is for your insurance and a portion is for the investment. Over time you can expect your investment portion to grow. But there is a problem with whole-life insurance. First, it costs too much. Very few families can afford to buy enough whole-life insurance to provide between six and ten times their income in benefits. Second, nearly every policy I have seen only provides the savings if you don’t die. What’s that you say? Doesn’t everybody die? Yes. So there is no real point to whole-life.

Think about it. If your insurance is for $100,000 and you have an investment portion worth $80,000, the only thing your family gets when you die is the $100,000. What is the point of the savings? You would be better off investing separately from your insurance. Besides, the fees involved with whole-life are bad for you, but good for your agent’s commissions.

A better alternative is term life insurance. How does term life work? Term life insurance works like your car insurance. You purchase it for a certain term. If you die during that term, your family gets the benefits. If you don’t, you get to live longer. You have to consider what term makes the most sense. If you are just starting out, you may want a 20-year term policy. That gives you 20 years to pay down your debt and increase your savings (including your 401(k)) so when your term runs out, assuming you are still alive, your family will not need any life insurance benefits because you have wisely saved enough money to cover all of the expenses we just discussed a few paragraphs earlier.

A good way of looking at this philosophy is “buy term and invest the difference.” Of course most of us do not do it this way, but nonetheless, if you buy term, you can use all the money you are saving in insurance premiums to pay off your house early and start a college fund for your children so you won’t need the insurance benefit 21 years from now.

Want to know more about life insurance? Visit New York  Life.

Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com or www.TheGraduatesGuide.com.

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7 Responses to A Financial Peripheral: Life Insurance

  1. Babu's Insurance Guide says:

    Your article was nice and clearly explains the need of the insurance. Your term “Buy term and invest the difference” was good.
    read more

  2. http://babusinsuranceguide.blogspot.com/ says:

    Your article is nice and clearly explains about the need of Insurance and “buy term and invest difference” philosophy fulfills the requirement of individuals.

  3. Insurance Reviews says:

    Got your points quite well. Insurers are very difficult to follow with their hard terms and conditions which they can change anytime they like. Anyways a great help from your post. I have found some important information at http://www.umerinsurance.com hope you like it as i did.

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  6. Chris says:

    You must have limited experience in dealing with Life Insurance, Bill. That, or you’ve only dealt with NML and NYL. (Only Term and Whole? Really? That’s it???)

    To anyone reading this, he’s right on throughout most of the article, but you need to take this for the background information, not the blanket advice. Find a financial professional that will lay out every option for you and your family, explain them, and allow you to make the decisions for yourself. We’re out there!

  7. ET says:

    It would be nice to read an article by somebody who really understands the pros and cons of different types of insurance. Clearly the author of this article does not understand the world of insurance and should not be advising people on buying life insurance. To really get a good understanding of different life insurance products you should speak to a career agent at a company like Northwestern Mutual, Mass Mutual, New York Life, or Guardian. Buy term and invest the difference only applies to the comparison of antiquated whole life products and equity investments that may or may not pay off. Today you can realize equity-like returns on a good whole life policy while also creating a substantial insurance portfolio, all with less risk than many other investments. Speak to someone who has access to top-tier products like Northwestern Mutual, Mass Mutual, Guardian, and New York Life and assess financial strength ratings, expense and mortality ratios of companies, and historic returns on cash value and death benefit.

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