Last week I reviewed the advantages of term insurance, so it seems natural to also review the disadvantages. I use the plural, but basically there is only one disadvantage, and that is using it inappropriately.
So how is it used inappropriately? Remember, term insurance is the preferred vehicle to cover a short term need or to cover a long term need when cash flow is insufficient to cover it with whole life. To use it otherwise is my definition of using it inappropriately.
The problem stems from the fact that many (most?) people think that the only difference between the two is the premium, and why would anyone in their right mind want to pay more for the same product that is available at a cheaper price? Sam Walton became a multi-billionaire using that very concept.
They aren’t the same product with a different premium structure though. That is a false premise, and if you start with a premise that you believe to be true but is actually false, it doesn’t matter how logical the argument is that follows, you will always get the wrong answer.
It has been my experience that the overwhelming reason people use term insurance inappropriately is because they think that they won’t need it at some point in the future. The thinking is that the kids will be educated, the home mortgage will be paid off, and the 401(k) plan will be ample.
Sure, if life goes exactly as planned, there’s a possibility that there will be no need for life insurance in the future. But how often does life go exactly as planned? Unfortunately, not very often. There are accidents, illnesses, home equity loans, job loss, divorce, kids getting divorced, kids moving back home, poor market results, financial crisis, etc. A myriad of potential setbacks, one or more of which is almost certain to occur.
Term insurance carries a significantly lower premium because it is designed not to be in force when you die. That is not some nefarious plot by the insurance companies to screw the public; it is just a simple business axiom that says that revenue must exceed costs for a business to remain viable, and if claims were likely on term insurance, the premiums would have be much higher.
So while term insurance does have its advantages, the disadvantage is that it is extremely unlikely that it will be in force the day you die. Maybe it’s just me, but it seems to be a prudent plan to have some permanent insurance. If you reach old age and it’s not needed, you can always surrender it for its cash value. But it’s analogous to a parachute: better to have it and not need it than to need it and not have it.