When it comes to life insurance, there are two main categories to choose from. However, recent data suggests that a significant number of households are opting for the less cost-effective option.

According to the American Council of Life Insurers, in 2021, Americans purchased a staggering 4.1 million term insurance policies, accounting for 40% of all individual policies sold that year. On the other hand, 6.3 million policies, making up 60% of the total, were permanent life insurance policies.

Interestingly, this contradicts the general advice provided by financial advisors.

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

So, what exactly distinguishes term insurance from permanent life insurance?

Life insurance acts as a financial safety net, providing beneficiaries such as children or a spouse with a death benefit if the policyholder passes away.

Term insurance pays out the death benefit only during a specified term, typically 10, 20, or 30 years. If the policy is not renewed, the coverage lapses at the end of the term.

In contrast, permanent insurance policies, including whole life and universal life, offer lifelong coverage until the policyholder’s death. These policies are often referred to as cash value policies due to their interest-bearing accounts.

According to financial advisors, permanent insurance generally comes with a higher cost. Premiums are spread over an extended period, covering both insurance costs and the accumulation of cash value.

“Term insurance will likely be the most cost-effective approach to meet survivor income needs, especially for minor children,” advised Marguerita Cheng, a CFP based in Gaithersburg, Maryland, and also a member of CNBC’s Advisor Council.

Premiums for life insurance policies can vary significantly based on factors such as the policy’s face value, the policyholder’s age, gender, health, family medical history, occupation, lifestyle, and other relevant factors.

Despite the advantages of term insurance, there are situations where permanent life insurance may be more appropriate, even with its higher premiums. Carolyn McClanahan, the founder of Life Planning Partners, outlined three primary reasons for considering a permanent policy, ensuring an insurance payout regardless of when death occurs.

For instance, beneficiaries with special needs, such as children, may require long-term financial assistance that surpasses the policyholder’s lifetime savings. In such cases, a permanent policy would be necessary.

Some policyholders may also wish to leave a financial legacy for their family or charities. Additionally, individuals with minor health complications that may worsen over time could become uninsurable in the future. For them, purchasing a permanent policy today ensures future coverage, even if their health deteriorates.

It is worth noting that some people buy permanent life insurance for the cash value, intending to borrow against it or use it as a retirement savings account. However, McClanahan strongly advises against this approach, stating that the primary reason for buying a policy should always be the insurance need.

Drawing excessive cash value from a permanent policy can lead to taxes, penalties, and inadvertent policy lapses, resulting in a loss of insurance coverage. Instead, policyholders should view the cash value as a last resort, similar to home equity, to be tapped into during emergencies at the end of life.

Determining the appropriate life insurance amount and term requires careful consideration of three aspects: liability, loved ones, and legacy, as suggested by Marguerita Cheng, CEO of Blue Ocean Global Wealth.

Consider the amount of money needed to cover liabilities such as mortgages, student loans, or auto loans if the policyholder were to pass away. Additionally, evaluate the financial support required for loved ones, including a spouse and children, in the event of the policyholder’s sudden loss of income. Finally, determine the desired legacy or charitable contributions to leave behind.

By addressing these questions, individuals can determine the optimal term for their policy. Cheng shared her personal experience, where she purchased a 20-year term policy with a $750,000 death benefit when all three of her children were under 18 years old. Her husband also had a stable income. In the event of Cheng’s premature death, each child would receive $250,000 to fund their education. Furthermore, Cheng obtained $250,000 of permanent insurance, intended to help her husband pay off their mortgage.

Combining term and permanent insurance policies can offer a cost-effective solution that surpasses the benefits of solely relying on permanent insurance, according to financial advisors.

When purchasing a term policy, it is advisable to select a “convertible” term insurance. This option allows policyholders to convert their term policy into a permanent one at the end of the term without undergoing additional medical underwriting. This is particularly useful if the person’s health deteriorates, as they may be denied coverage if they were to reapply later.

In conclusion, while permanent life insurance may have its advantages in certain situations, the majority of individuals can benefit from the cost-effectiveness of term insurance. By carefully considering their needs, liabilities, and long-term financial goals, individuals can make informed decisions when purchasing life insurance and secure the financial well-being of their loved ones.