Advisors recommend term life insurance as the optimal choice for the majority of individuals

When it comes to life insurance, there are two main types, but it appears that many households are not opting for the most cost-effective option.

According to the latest data from the American Council of Life Insurers, Americans purchased 4.1 million term insurance policies in 2021, representing 40% of all individual policies bought that year. However, permanent life insurance accounted for 6.3 million policies, making up 60% of the total.

This conflicting information contradicts the general recommendation of financial advisors.

“Most people simply need term insurance,” said Carolyn McClanahan, a certified financial planner and member of CNBC’s Advisor Council.

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Life insurance provides financial protection by paying out a sum of money to beneficiaries in the event of the policyholder’s death.

Term insurance, on the other hand, offers coverage for a specified term, often 10, 20, or 30 years. If the policy is not renewed, the coverage expires.

Permanent insurance policies, such as whole life and universal life, provide continuous coverage until the policyholder’s death. They are also known as cash value policies due to their interest-bearing accounts.

Advisors generally agree that permanent insurance tends to be more expensive. Premiums are spread out over a longer period and are used to cover insurance costs and build cash value.

“Term insurance is usually the most cost-effective solution for addressing survivor income needs, especially for minor children,” said Marguerita Cheng, a certified financial planner and member of CNBC’s Advisor Council.

Premiums vary based on factors such as the policy’s face value, the policyholder’s age, gender, health, family medical history, occupation, lifestyle, and other considerations.

According to Carolyn McClanahan, there are three main reasons why buying a permanent policy might be more suitable, despite the higher premiums. These reasons ensure an insurance payout regardless of when the policyholder passes away.

For instance, beneficiaries with special needs may require long-term financial support that a policyholder’s savings alone cannot provide.

Some policyholders may also wish to leave a financial legacy for their family or charities. Additionally, individuals with minor health complications that could worsen over time may find it beneficial to purchase a permanent policy to secure coverage in the future.

Some individuals may purchase permanent life insurance for its cash value, intending to borrow against it or use it as a retirement savings account. However, according to McClanahan, this is not a valid reason to buy a permanent policy. The primary purpose of purchasing life insurance should always be for insurance coverage.

Accessing the cash value of a policy may result in taxes and penalties. Withdrawing or borrowing excessive amounts from a permanent policy could unintentionally cause the policy to lapse, leading to the loss of insurance coverage.

Policyholders should treat the cash value as an emergency fund to be used toward the end of life, similar to how one might utilize home equity, McClanahan explained.

When deciding how much life insurance to obtain, prospective buyers should consider the “three Ls”: liability, loved ones, and legacy, advised Marguerita Cheng, CEO of Blue Ocean Global Wealth.

For example, individuals should determine how much money they would want to leave behind to cover liabilities like mortgages, student loans, or auto loans in the event of their death. Additionally, they should consider how much money their loved ones would need to replace the policyholder’s income. Finally, individuals should reflect on how much they would like to leave as a legacy for causes they care about.

These considerations help guide the term of the policy, according to Cheng.

Cheng offered her personal situation as an example. She purchased a 20-year term policy with a death benefit of $750,000 when all three of her children were under 18 years old. Her husband also has a regular income. In the event of her premature death, each child would receive $250,000 for their education. Cheng also bought $250,000 of permanent insurance to help pay off the mortgage, providing additional financial security for her husband.

Combining term and permanent insurance policies can be a cost-effective approach compared to solely purchasing permanent insurance, as advised by financial advisors.

When buying a term policy, individuals should ensure it is “convertible.” This allows policyholders to convert their term policy into a permanent policy without undergoing another round of medical underwriting once the term has expired. Otherwise, individuals may be denied coverage if their health has deteriorated.