What Is Whole Life Insurance and How Does It Work?

If you have loved ones who depend on your income, you need life insurance. After all, you want to know they’d be well taken care of if anything ever happened to take you away from them. And since most families have dependents, the market for life insurance is gigantic.

What you may not know is that many insurance companies will take that broadly felt need and steer folks toward whole life insurance—which is a terrible option (for many reasons). Companies market it as this awesome product that lasts your entire life (which it does, but so does a life sentence) and then hype it up with buzz words like “fixed premiums” and “cash value accounts” to lure you into buying a policy.

But just like those extended warranties you can buy for the price of a light bulb (really?), whole life insurance is a way better deal for the company selling it than it is for you.

Don’t fall for it! We’re here to tell you all the stuff whole life insurance companies won’t. By the time you’re done reading this, you’ll see why term life insurance is always the best option.

What Is Whole Life Insurance?

Whole life insurance policies package life insurance coverage—which pays a benefit to your loved ones when you die—along with a savings or investment account that’s supposed to build cash value.

How Does Whole Life Insurance Work?

Whole life insurance often comes with a guaranteed return on your cash value, but the average returns on these accounts are pretty low. Lower returns are easier to guarantee, right? But that’s just the beginning of the bad news about whole life.

Let’s take a closer look at how it all works.

Permanent Life Insurance

Whole life insurance is a type of permanent life insurance. Basically, that means it provides coverage for your entire lifetime (as long as you keep paying your premiums on time, that is).

But here’s the thing: Life insurance doesn’t need to be permanent, nor should it be. The point of life insurance is to replace your income if you die, which is exactly what term life insurance is designed to do (more on that later).

So, if you can become self-insured over time (which means you have enough money saved and invested to cover anything an insurance company would usually pay for) then you won’t need life insurance at all. Most people following the Ramsey Baby Steps can become self-insured in 15 or 20 years, tops. That’s a major milestone worth chasing!

Cash Value Component

Whole life insurance policies also include a cash value component that grows over time. The point is to provide a savings or investment feature in addition to the death benefit. Sounds awesome, right? Well . . . not quite.

We already mentioned a whole life policy will give you a guaranteed (but unimpressive) interest rate on your cash value account. If these accounts were race cars, they’d be 1991 Yugos—slow and unreliable. (We’ll recommend some better investment vehicles further down the road.) Just like in a typical savings account, your cash value is supposed to grow.

And after you’ve built some savings, you can access the money in any of three ways:

1. You can make a withdrawal.
2. You can borrow against the cash value of your policy (basically taking out a loan).
3. You can surrender the policy and withdraw the entire cash value of the account.

But all of those go against the original purpose of the investment, and have a lot of other downsides, which we’ll explain in a minute.

Level Premiums

Premiums for whole life insurance stay the same throughout the life of the policy (that’s why they’re called level premiums), which is a lot better than you’ll see with other types of permanent life.

Compare Term Life Insurance Quotes 

With a whole life policy, the insurance company uses part of your monthly premium to cover your life insurance costs and then puts the rest into a cash value account.

The breakdown of how much is invested versus how much goes toward your policy changes over time. In the earlier years, a larger percentage of your premium goes into the cash value, while in the later years, more goes toward your life insurance coverage since the cost of life insurance increases as you age. (If that’s confusing, ask yourself, Who’s more likely to die this year, me or my great-grandpa? That’s why it’s costlier to insure gramps.)

But do you know which other kind of life insurance has fixed premiums? It’s called level term life insurance. (Spoiler alert: It’s way more affordable than whole life, and it’s the only kind of life insurance we recommend.)

What Are the Advantages of Whole Life Insurance?

Now that we’ve walked through the basics of whole life insurance, we’ll go over the (few) benefits and (many) drawbacks of a whole life policy.

Let’s start with the pros.

Death Benefit

Just like every other kind of life insurance, whole life policies provide a guaranteed death benefit to the beneficiaries after the death of the insured. And that will be paid no matter when the insured passes away, as long as the policy is active.

(But we think you’d do way better for your family if you buy term life insurance to cover your dependents until they’re grown and on their own, while investing in tax-advantaged retirement accounts that you can use in retirement or leave as an inheritance to those lovely grandkids.)

Tax-Deferred Growth

The cash value grows on a tax-deferred basis, which means you won’t pay taxes on the growth of the cash value so long as you keep your withdrawals under the total amount of premiums you’ve paid in. But as soon as your withdrawals dip into the gains, they will be taxed as income.

There are plenty of other ways to avoid taxes on investments that also happen to provide far better returns. But at the end of the day, a tax shelter is always a benefit.

Dividend Payments

Some whole life policies may pay you dividends, which can be used to increase the cash value, reduce premiums, or purchase additional coverage. (But again: Many investments inside of tax-advantaged retirement accounts also pay dividends to investors.)

Cash Value Growth

The cash value of a whole life policy grows over time through a combination of premium payments and interest credited by the insurance company.

For the third time, though: These returns are quite modest. And they aren’t nearly as good as the kind of growth you’d expect from other investments, like good growth stock mutual funds.

The thing is, the cash value account of a whole life policy is a big part of why the premiums are so much higher than what you’ll pay for term life. So even though it’s promoted as a big benefit, the measly growth is more of a con than a pro.

What Are the Disadvantages of Whole Life Insurance?

And speaking of the cons, let’s talk about those. We’ve got a lot of ground to cover, so let’s get right down to it.

Cost

Whole life insurance premiums are usually far higher than term life premiums, for several reasons:

• Lifetime coverage
• The cash value feature
• Lots of fees (see below)

To give you an idea of the gap size in premiums, here are a few comparisons.

Monthly Premium Cost by Age and Gender

Rates displayed are based on a $1,000,000 policy for non-smokers in the Preferred Plus health classification; 20-year term length and whole life quotes are from American General Life Insurance Company. Individual rates will vary based on applicant-specific information.

Surrender Charges

You may have to pay a surrender charge if you cancel the policy in the first years after you bought it, shrinking the cash value you’re able to withdraw.

Here’s how that works. You tell the insurance company you want to cash out your whole life policy, and they send you a percentage of the policy’s cash value. How much money you get back depends on:

• Your particular policy
• The insurance company fees, and
• The amount of time you’ve had the policy

Pretty much no matter how you decide to tap into the cash value of a whole life policy, it’ll never work out in your favor. Either your cash value will lose a lot of its worth because less and less of your premiums have been invested over the years, or you’ll have to settle for less than the full value of the policy you’ve been paying for. Either way, it’s not a good choice.

Risk of Losing the Cash Value Completely

If you didn’t do anything with that cash value while you were alive, guess what happens when you die? The insurance company might just keep it! Depending on the policy, your family will get the death benefit, but the insurance company nabs your cash value account. (This is one of the worst parts of cash value life insurance and why we’ll always tell you to steer clear of it.)

Policy Loans and Withdrawals

If you have whole life, you can access the policy’s cash value through loans or withdrawals. The marketers promote this almost like some kind of emergency fund. But that’s kind of a dumb way to treat the money you would theoretically leave behind for your family if you died.

And while most whole life policies will let you borrow against them, doing this isn’t as good of a deal as it seems.

Think about it. Like any loan, if you borrow against the cash value, you’ll have to pay interest as you pay it back, even though it’s technically your own money. How crazy is that?

And it gets worse. If you don’t pay back the money you borrow, your insurance company will take that amount out of your death benefit—and it’s not always dollar for dollar. That means your policy can be reduced by more than the actual cash amount you borrowed. Harsh!

Opportunity Cost

The main thing to know about whole life is that the growth of the cash value in a whole life policy will pretty much always pale in comparison to other investment and savings options.

Paying for a life insurance policy long past the time you really need it is bad enough. But the time and money lost investing for years in such low returns makes it an even worse idea.

Pros and Cons of Whole Life Insurance

Whole Life vs. Term Life: Which Type of Life Insurance is Better?

Simply put, term life is both far cheaper and far easier to understand than whole life. That’s because term life is just life insurance. Since whole life has a cash value element, its premiums are a lot higher than term life premiums. And when we say higher premiums, we mean outrageously high.

Do you really want to pay hundreds or even thousands of dollars more every year for life insurance, just so you can have a cash value account with a low interest rate? No thanks!

You can invest smarter with term life insurance.

People buy whole life because they think they’re killing two birds with one stone. They get life insurance and an investment. When you really think about it though, using your insurance as an investment makes no sense—especially when there are better investment options out there.

You can easily get more bang for your buck by getting term life and then investing the money you’d save every month on whole life premiums for retirement. This is so important—be very wary of any type of insurance acting as an investment opportunity.

Insurance companies make more money on whole life insurance.

Who really benefits from whole life insurance? The truth is the insurance companies and agents who sell it are the ones profiting. They make a heck of a lot more money on whole life policies than they do with term policies, so which one do you think they push more?

Remember, you’ll pay a much higher premium for a whole life policy than for a term life policy. Insurance companies use that expensive whole life premium to invest your money for their profit. Don’t fall for it!

The Bottom Line on Whole Life Insurance

The cash value part of a whole life policy can sound like a good deal. We get it—everyone needs to think about building their retirement fund. But a whole life policy isn’t the way to do it.

Instead, invest 15% of your household income in good growth stock mutual funds through tax-advantaged accounts, like a 401(k) or Roth IRA. You’ll build wealth faster and be in a much stronger position when it’s time to retire.

Whole life insurance—and the lousy way it builds up cash—just can’t compare to the results you get by investing your money independently. Don’t leave investing to your insurance company, and skip whole life insurance!