Universal life insurance often comes up when you’re searching and shopping for life insurance. But it’s a complex product that can be hard to understand when you try to unravel the costs and risks.
Universal life insurance is a type of permanent insurance that offers a death benefit and a cash value component that acts as a savings account and can grow over the life of your policy. Universal life, like any other permanent life insurance policy, is designed to provide lifetime coverage since the premiums can stay level for as long as you live.
The cash value account feature of universal life insurance, especially as it can potentially be used to cover your premiums over time, may be attractive to those shopping for insurance. However, for most people, the much higher premium costs, fees, and risks make term life insurance a better option. Indeed, those complexities have led to a large number of people losing their policies over the last few years, after paying premiums for decades.
It’s a good idea to have a very deep understanding of a product like universal life insurance before you purchase.
Here are a few details you need to know.
How universal life insurance works
Universal life insurance is a type of permanent insurance. Which means, as long as your premiums are paid, you’ll have life insurance. The policy never expires.
But although life insurance at any age is a draw, what makes permanent life insurance attractive is usually the cash value that can grow over time. As you pay your premiums, a universal life insurance policy has the potential to accumulate a cash value.
In a universal policy, that cash value earns interest at the greater of the current market rate or a minimum interest rate set by the policy. This means the cash value has less growth potential than in a variable life insurance policy, where cash value is invested in the market, but possibly greater security because of the policy’s minimum interest rate.
Unlike a whole life insurance policy, which has fixed premiums over the life of the policy, universal life insurance offers flexible premiums. If there is enough cash value, policyholders can use that value to cover fully or partially their monthly premiums. They also have the option of paying more than their standard premium to bolster the cash value of their account.
If this flexibility seems attractive, remember that flexibility inevitably goes both ways.
Contractual premiums of universal life insurance typically remain the same over the life of the policy. However, if a customer uses the cash value to help pay premiums and the cash value is diminished, the difference between the cash value and the death benefit will be higher than anticipated and will eventually require the customer to pay higher premiums than planned. That can mean higher – sometimes much higher – monthly payments to keep the policy in force. Before choosing universal life insurance, consider whether the potential benefits offset these costs.
How does universal life insurance work?
Universal life insurance has three important components: premiums, death benefit, and cash value.
The premium is what you pay for your policy every month. Universal life insurance premiums are split between the cost of coverage – the amount to keep your life insurance coverage – and the cash value. Each month you can determine how much you wish to pay as long as it is between your policy’s minimum and maximum payments.
You can use the cash value to pay premiums once you’ve built up enough. But if your cash value runs out, or interest rates don’t allow it to keep up with the increasing cost of insurance over time, you could end up owing higher payments. And since the cash value is typically equal to the surrender value, not making those payments could result in a double loss – no longer having life insurance coverage and no surrender value for the lapsed policy, even after years of payments.
The death benefit is your life insurance coverage amount and is how much your beneficiary will receive when you pass. Universal life policyholders often have some ability to increase or decrease their coverage amounts based on their needs.
Regarding the cash value is the savings account, each time you make a premium payment, a portion is put towards your cost of insurance (the amount to keep your death benefit active and cover administrative fees) and the rest is placed in your cash value account.
With universal life insurance, the cash value is guaranteed to grow at a minimum annual interest rate, but it has the potential to increase faster based on market interest rates. If the cash value grows, it can be used as loan collateral if you wish to borrow from your policy or used to cover premium payments.
If you decide you no longer want your universal life insurance policy, you can surrender it to the insurer and get the cash value in return.
Pros and cons of universal life insurance
Universal life insurance is a type of life insurance that combines permanent life insurance coverage with a cash value component and some flexibility around premiums and coverage levels.
To some, the benefits seem attractive.
- Premiums and death benefits are flexible. If you want to contribute less to your policy in a given month, you can, as long as your payment is above the minimum threshold. And if your needs for insurance change over time, you can often adjust your death benefit.
- You get life insurance coverage for your entire life. Your heirs will receive a death benefit no matter when you pass, as long as your premiums are paid up.
- Lower cost permanent insurance than whole life. Universal life insurance guarantees a minimum return over time, but the return is often lower than the fixed whole life insurance cash value interest rate. That means premiums for universal life insurance are generally less expensive than premiums for whole life insurance. And in high-interest rate environments, your cash value may grow faster with a universal life insurance policy than whole life.
Universal life insurance comes with a few downsides you should consider.
- Premiums are expensive. While universal life insurance premiums are generally cheaper than whole life insurance, they will always be much more expensive than the premiums for a term life policy during the policy term. A $500,000 universal life insurance policy for a 40-year-old male in excellent health can be $249.50 a month, compared to as little as $32.38 for a 20-year Haven Term policy.
- Your insurance cost isn’t fixed. Universal life insurance premiums are split between the cost of insurance coverage and the cash value. But as you age, the cost of insurance increases in most policies, up to a maximum amount set at the start of the policy. If your cash value is diminished, this can mean much higher premium payments later in life or even the loss of your policy.
- Loans will come with interest. Interest will be charged on any loan amount. Unpaid loans and interest will reduce the policy’s cash value and the death benefit.
Many people with a conservative risk tolerance will use universal life insurance to accumulate funds on a tax-deferred basis, especially if they have a lifetime insurance need. However, for people who need coverage for a defined period, they can buy affordable term life insurance.
Term life insurance as an alternative to universal life insurance
If your main goal is protecting your loved ones with life insurance when you need it most – while your children or young or you are still early in your retirement savings – term life is often a lower cost and more efficient choice.
Get the coverage you need, when you need it and for a much lower cost with term life insurance. The premium savings can be put towards your other goals and investments so you can build the future you want.
Chelsea Brennan is the founder of Smart Money Mamas, a personal finance blog that focuses on family finance, investing, and reducing money stress. Chelsea is an ex-hedge fund investor whose work has appeared in a wide array of publications, including Forbes, Business Insider, and more.