I'm 25 years old. I have a good job, no kids, no wife, no student debt, no mortgage, and I'm healthy with no intention of getting sick. So why would I sacrifice a portion of my income toward life insurance? Well, there is more than one reason. The most concrete reason is that I am analytical and the numbers make sense. By purchasing a life insurance policy now I am saving myself a significant amount of money in the future. As with anything in finance, if you pay upfront it costs less. It's like when you buy a house with a mortgage it ends up costing significantly more over the term of the mortgage (which is justified by the time value of money but more on that later). I will discuss two types of insurance: guaranteed whole life insurance, and limited pay life insurance. Guaranteed whole life insurance is a type of policy that is paid until the age of 100 and builds cash values, and limited pay life insurance is fully paid for in a set number of years, and also builds cash values. I have used a Pay 20 policy - a limited pay policy that is paid for in 20 years - in my examples.
The best deal for young people, as far as total overall cost goes, is limited pay insurance. Looking at a Pay 20 policy, the overall cost of $250,000 of permanent life insurance for a 25 year old male is $38,071 paid over a 20 year period (monthly premiums of $159). The cost goes up at increasing intervals every year after this. Purchasing a Pay 20 policy at age 40 would end up costing $73,711, $35,640 more than the same policy purchased at age 25.
To make a fair comparison of the costs of permanent life insurance for a young person, it is also important to see what a guaranteed whole life policy looks like. Guaranteed whole life policies have significantly lower monthly costs, but the payments are made until age 100, instead of for 20 years. Payments are constant for the duration of the contract, but the level cost increases with each additional year of age. If purchased at 25 the monthly premium that will remain for the duration of the policy is about $99, whereas it is about $203 if purchased at the age of 40.
So it's not hard to see that the total financial impact of waiting to buy life insurance is significant, and choosing to pay monthly over a longer period of time rather than over a set period of time also has a huge impact on overall costs.
Now that we are looking at the cost over time, it is necessary to introduce the time value of money for proper analysis. For anyone not familiar with finance, I will let Investopedia explain what the time value of money is:
The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Learn more in this video.
With that in mind, what happens if we look at the cost of permanent life insurance while taking the time value of money into account? The formula to find the present value (the dollar amount adjusted for its potential future earning power) is found using the formula:
where PV is the present value, fv is the future value, i is the interest rate, and t is the amount of time. I have used a conservative interest rate of 3% for my calculations.
After discounting the cashflows, the differences in cost between the two types of insurance are less drastic but still significant.
To purchase a Pay 20 policy as a 25 year old would require cash flows with a present value of $28,327, and purchasing the same product at age 40 would require cash flows with a present value of $54,838. Now because these cash flows have been discounted over the same time period it is not very exciting. When we examine the cost differences between Pay 20 and guaranteed whole life insurance, the dissimilar durations of payments make it far more exciting.
When a guaranteed whole life policy is purchased, it is paid until the age of 100 (or until death), so there are different time periods that we need to use to discount the cash flows (ie. if purchased at 20 there are 80 years of payments, purchased at 30 there are 70 years etc.). Purchasing a guaranteed whole life policy at age 25 requires cash flows with a present value of $35,374 and at age 40 the required present value of cash flow is $67,556. After accounting for the time value of money, guaranteed whole life insurance and Pay 20 life insurance are not as drastically different in cost, but the fact is that guaranteed whole life insurance is still more expensive.
The following chart offers a comparison of the total costs of insurance without taking the TVM into account.
Now, applying the time value of money we will see that even after discounting the long durations of smaller cash flows it is more cost effective to purchase Pay 20 permanent life insurance than it is to buy guaranteed whole life insurance, and it is far less expensive to buy life insurance at 25 than it is to wait until later in life.
So, why would I buy life insurance at 25? Like I said, the numbers answer that question for me. Even after adjusting for TVM, I will be saving myself a significant amount of money in the long run by paying into my Pay 20 policy now. I told you that there are multiple reasons for buying life insurance at 25, and there are, but that will have to be my next post.