How do I evaluate the Time value of money when buying term insurance?

Question

I am currently evaluating buying a term insurance and very confused with few concepts around time value and evaluating the right option.

• Regular payments - you pay for 30 years lower amount now but higher total
• Limited payment - you pay for 10 years higher amount now but lesser total

I thought of evaluating the situation by finding the present value of money in both the cases for each year. Idea was to estimate how much does it cost me in today's money in total to understand which is cheaper.

Formula used - amt/((1+r)^term)

This is where my confusion started r- discount rate( say risk less investment in a bond with 8% return)is usually defined opportunity cost you lose by not investing that money. Amount I am losing by not investing the amount but paying upfront.

Problem is, I donot have all that money right now to keep it invested and take regular cashouts to make it payments. That money will be earned in that year only.

So does it make sense to calculate PV in this case where the assumption is that money is invested and hence you are discounting by that rate.

What would be the best way to evaluate this? Shall i take a diff of monthly installments and find that missed growth? In that case, shall I also consider the monthly diff after 10 years since I will be saving that and can be invested at that time too which is full instalment amt of 30 years plan invested for 20 years?

Answer 1

Time value of money boils down to what you would be doing with that money if you weren't doing this.

Take me to the extreme: if I give you $1,000 now, then in 10 years it is worth $1,000 plus interest minus inflation, measured in today's dollars thank you sir. If I give you $1,000 in 10 years, it is worth $1,000 minus inflation. The interest - the value of having the money earlier - is what is meant by time value.

In the same way, making higher payments earlier means that the recipient gains more interest over that time, since interest compounds. It also means you lose more interest, for the same reasons.

To compare the two options, you need to actually run the numbers. Although, often, when a business offers options like this they have been selected to come out to the same total profit for them and the choice really comes down to one of convenience.

Answer 2

What would be the best way to evaluate this?

There are two ways to look at this - either calculate the Present Value (PV) using a constant discount rate like you tried or calculate the "Internal Rate of Return" (IRR).

Calculating the PV is straightforward but is highly dependent on the right discount rate. A typical discount rate is either the return you'd expect to get from an investment of equivalent risk, which is this case is risk free since your payments are guaranteed, or at what rate you could borrow the money, which would be higher than the risk-free rate. If you have any debt, I would use the higher rate since the alternative would be to put that money towards retiring the debt.

The downside of using PV is that using the wrong discount rate can give you the wrong answer as to which is "better". If you use too high of a discount rate, paying more later will look like a better deal since those payments are discounted more. If you lose too low of a rate, paying a flat amount will look better since the later payments aren't discounted enough.

The IRR is a better comparative measure in my opinion since it tells you the discount rate at which each the deals break even (have a zero present value). The one with the lower IRR is the better deal since you're paying money instead of investing it. The IRR is not straightforward to calculate by hand but it easy in excel or other tools.

That said, I wouldn't stress too much over the IRR or PV. Paying less now and more later might be much better from a cashflow standpoint, and the difference in IRR between the two might now be enough to worry about. Just having life insurance is the goal - which way you pay for it is a minor detail in my opinion.

Answer 3

Direct answer: The easiest way to do this these days is to use a spreadsheet. Make a column, say column A, for year. Make another column, say column B, for net present value of what you've paid in to the insurance. Then each year this is the previous value times the assumed return rate plus the premiums added. When I do this I usually put the rate and the premium in cells rather than hard-coding them so I can play with the numbers.

But several comments: 1. There is no such thing as a "risk free rate" -- every investment has SOME risk. What's relevant is the expected rate of return. If, say, you invest in the stock market, sure, there's no guarantee that you will make any given amount. You might even lose money. But you can find the average return over the long term. (Which turns out to be about 7%.)

You might want to include additional columns for other things you are considering doing with your money. Of -- I didn't quite follow the options you are describing, but one column for option #1 and another column for option #2.

2. Putting money into a term insurance policy is almost always going to look worse than investing in the stock market or real estate or whatever. Because the whole point of insurance is that if you die young, your family still gets the big payout. If you knew for a fact that you were going to live another 40 years -- your astrologer guarantees it or whatever -- then it would be foolish to buy life insurance. There are many investments that would pay off much better. But if you knew for a fact that you are going to die in a year, than life insurance would be a great investment.