Common Uses of Decreasing Term Life Insurance
It’s likely that you already have a good grasp on the differences between whole life and term life insurance from insurance school, but let’s take a deeper dive into the nuances of term life insurance with respect to decreasing limits.
First, understand that term life insurance is generally the best option for most people. But an understanding of decreasing term life insurance may be helpful as you embark on your career following successful completion of your insurance exam.
Decreasing term life insurance is a kind of term life that provides a death benefit that gets reduced over the course of the policy, but the premium remains constant. You read that right: you make the same premium payment each month (or annually, depending on the policy requirements) but the benefit payout is reduced as time goes by—either monthly or annually.
But why would someone choose to go this route? Good question. In theory, someone may have an interest in a decreasing policy to cover a mortgage that also gradually reduces over time. In exchange for a potentially reduced premium, they purchase a life insurance policy with a decreasing benefit in step with a decreasing loan. However, as we’ll see, there may be better ways to prevent over insuring someone.
Before we go any further, it’s important to know that most insurance companies now don’t even offer decreasing term life insurance, so it may not even make sense to consider it at all.
In any case, here’s a look at how decreasing term and level term life insurance stack up:
When does decreasing term life insurance make sense?
As mentioned above, decreasing term life insurance is often seen as mortgage insurance. It’s possible you may have encountered this when applying for a mortgage. The lender may have offered a kind of decreasing term life insurance also known as mortgage protection insurance, or MPI. Mortgage protection insurance is a policy that you buy from the lender and may be included in your mortgage payment. However, if you die while coverage is in place, the policy pays the benefit directly to the lender—and not a beneficiary of your choosing.
This is different from private mortgage insurance—or PMI—which is an insurance policy that many mortgage companies require if a borrower puts less than a 20% down payment. Private mortgage insurance is not life insurance but instead protects the mortgage company if the house is foreclosed.
Other life insurance options:
Since level term life insurance is fairly affordable, decreasing term life policies rarely make much sense. Nevertheless, if the main reason to buy life insurance is to make sure that a loan is covered in case of death, the decreasing policy may be a possibility. Of course, you’ll have to find an insurance company to write the policy first. With this in mind, there are two better choices if you want to cover decreasing loans.
A better choice in most scenarios would be to purchase a level term policy, decreasing the face value of the insurance policy as the loan is paid down. Plus, with a level term life policy, if the face value is reduced the premiums will be reduced correspondingly.
A second option would be to use the ladder approach, which basically means stacking (or “laddering”) the limits of several term policies that expire in succession as the loan is paid down. As a bonus, by stacking policies in this way you may pay less in premium over the lifetime of the policies than if you had a single term policy.
The ladder approach is based on a fairly simple principle: The older you get, the less life insurance you need. Life insurance at its core is intended to provide coverage for your financial responsibilities if you die at a relatively young age. As you pay off loans and as your children become adults the need to provide for beneficiaries decreases.
So, using that rationale, it might make sense for the face value of your life insurance policies to decrease as well. However, that’s not how these policies usually work. For example, let’s say we have a 20-year, $250,000 term life policy for which we pay $25 in premium per month. We’ll pay that same $25 monthly for the life of the policy—the full 20 years.
When laddering may not make sense:
While laddering is a sound financial strategy, an argument can be made against stacking limits for younger individuals.
As an example, if you’re 26 years old and are looking for $1 million of life insurance, you might consider just purchasing a single 30-year policy, rather than trying to split it up. While you may save a bit of money vs. a laddering approach, the total savings likely wouldn’t be worth it. As you get older, you can always reduce the death benefit and reduce the premium payments accordingly.
However, if you’re in your 30’s or 40’s and are buying life insurance for the first time, the laddering approach can work well.
As noted above, the laddering strategy assumes that insurance needs will decrease as a person gets older. But unanticipated financial responsibilities often happen, such as a mortgage refinance, adult children returning home temporarily, or buying a vacation home.
The plan that an insured initially had carefully arranged ends up changing, along with life insurance needs. To properly execute the ladder strategy, it is crucially important that an individual purchase term life insurance from an insurance company that will allow a conversion to a permanent life policy that provides for the flexibility to maintain the policy if needs change.
Be sure to let your beneficiaries and heirs know about the life insurance policies, including how many policies you have, where hard copies are kept, and with what insurance carriers. This can save time and needless additional anxiety when the time comes to pay a benefit.
Lastly, when it comes time to pay premium installments, remember that you have more than one policy in place. Letting policies lapse for non-payment can quickly ruin the ladder strategy and potentially put your heirs in a significantly underinsured situation—just because you forgot to pay the bills.