January 18, 2007

term life: buy now or buy later?

(This is a long one, but I think its pretty interesting if you’re finance-geeky)

if you've talked to me lately, you'll realize that I’m not a huge fan of whole life, variable life or any type of cash value life insurance policy. Part of that has to do with bitterness from having been sucked into one such policy a few years ago (one of the worst financial decisions of my life). Another part of that is that I ignored such clear advice from independent experts. Such as this, this and this.

Anyway, making the case against whole/variable life can come later, but this post is about how I came to realize that holding off on buying term life insurance makes sense if you aren't married/don't have any dependents.

Some background -- a fallacy that I’d been following was that buying term life when I was younger was ideal because it helps me to lock in a lower premium. But I talked to a former math major who did some actuarial stuff for insurance companies and he helped me realize that $400 in today's value is not necessarily less than $500 in tomorrow's value (hypothetically speaking). Ok, so here's the set up. I was wondering, "Hmm, should I buy a $500k policy today, at $295/year for the next 20 years?" I’m single, have no children -- legitimate or ill- -- and so no one really depends on my income. If I didn't buy today, the alternative would be buying (again, hypothetically speaking) in five years, when I may have a dependent. but if I wait five years to buy a policy for the same term (20 years) and coverage ($500k), my annual premium goes to $310 (the annual premiums are quotes I got off Fidelity's insurance quote tool).

Blah Blah, too many words in paragraph form. What does this scenario look like graphically? Below is a table to illustrate:

As the table above shows, if I were to buy term life now, I would:
  • End up paying $5,900 for coverage that ends when I'm 47.
  • 10% (2 years) of the term of my policy will be in force during a time when I'm fairly confident I'll have no dependents. On the flip side, from ages 48-52, when I *might* have a dependent or two, I'll have no coverage.

If I were to wait five years, then I would:

  • End up paying $6,200 for coverage that doesn't start until I'm 33, but ends when I'm 52.
  • All of the years of my policy will be in force at a time when I *might* have dependents, and zero when I'm certain I'll have no dependents.

Ok, so you may be thinking, hmm, the stuff about being insured when you’re more likely to have dependents makes sense, but still, you do save $300 by buying now versus later. But as the table below shows, there's another cost to consider.

What the table above shows is what would happen if I were to take money I would've paid towards a life insurance premium and invested it in the years when I didn't have a policy in place. So in the "buy now" scenario, I wouldn't have premium money to invest until I’m 48, when I could invest $310/year (I use $310 because that's how much I would be paying if I waited). In the "buy later" scenario, I would have $295/year to invest ($295 b/c that's how much I would've paid if I bought now) right away, for the next five years.

Assuming a conservative 6% annual return and investing only a total of five years, it’s clear that the power of compounding benefits me most in the "buy later" scenario. When I’m 52, my total return on investment in the "buy now" scenario would be $1,747 while my ROI in the "buy later" scenario would be $5,333 (in other words, more than 3x greater). So what are the final numbers? Yes, there IS another table to illustrate! =)

(I feel like some finance professor or worse, a financial advisor.)

So if I were to buy now, after paying 20 years of premiums and investing five years of the alternative premium payment of $310/year, and receiving a return of $1,747, I would be down about $5,700 while receiving insurance coverage. On the other hand, if I were to buy later, after 20 years of premiums and investing five years of the alternative premium payment of $295/year, and receiving a return of $5,500, I’d be down only $2,140. Just that alone would make a strong case for buying later. What makes the case even stronger is this -- remember, I still have the investments going and compounding (even conservatively at 6%). but at the "buy later" scenario, my "base" at age 52 is 3x more than my base in the "buy now" scenario. That means even though the returns will grow at the same rate, the actual amounts will be higher if I wait!


Byebye said...

but what if in 2 years you get married..and in 4 years you come down with some sort of illness that can cause your insurance premium to skyrocket? Maybe I'm just bitter that I already bought term life...

not confucius said...

Definitely good points. This scenario was based on assumed good health during the next five years. But we know what happens when we assume... =P

DH said...

Talk of term life insurance makes me hot.