Comparative Interest Rate Method

What Is the Comparative Interest Rate Method?

The comparative interest rate method is a way to calculate the difference in cost between two different types of insurance policies. Specifically, the comparative interest rate method is used to illustrate the difference between the cost of a whole life policy and a decreasing term policy with a side fund.

The comparative interest rate method offers potential policyholders and their agents the ability to make comparisons in costs and benefits across the two different types of products. Since interest amounts change, the value of the products can also change over time, as can an individual’s needs.

How the Comparative Interest Rate Method Works

To understand the comparative interest rate method, it is helpful to first review the structure of the two types of life insurance products that it is used to compare: whole life policies and decreasing term policies. In a whole life policy, the policyholder pays monthly insurance premiums for their entire life and is guaranteed coverage as long as they continue making their payments. Often, the whole life premiums will be fixed at a level that is much higher than what a young and healthy person could obtain within a decreasing term policy, with the advantage being that the coverage will still be in effect once the policyholder is old and infirm. 

The value of a whole life policy slowly accumulates over time, building equity which the policyholder can borrow against subject to the terms and conditions of the policy. Once the policyholder dies, their beneficiaries can collect the balance of the policy in a lump-sum death benefit, or request that it be paid out in dividends. These types of policies are also sometimes referred to as permanent or traditional life insurance policies.

Decreasing term policies, on the other hand, do not accumulate equity over time. Instead, the policy is only active while the payments are being made, but once the term has ended, there is no residual value left over for the policyholder. To address this, some decreasing term policies have side funds attached to them, which are essentially investment funds offered alongside the decreasing term policy. In that scenario, a portion of the policyholder's monthly premiums are directed into the side fund and invested on the policyholder’s behalf. 

The comparative interest rate method is a way to compare the attractiveness of these two types of policies. It consists of comparing the side fund’s expected rate of return with the rate at which equity accumulates within the whole life policy.

Real-World Example of the Comparative Interest Rate Method

To illustrate, consider the case of two hypothetical life insurance policies. The first is a whole life policy that carries a monthly insurance premium of $500. The second is a decreasing term policy with a 30-year term, an annual insurance premium of $100, and a side fund with an expected annual return of 2%.

Suppose that, in comparing these two policies, you are a 30-year-old in perfect health. You reason that, if you purchase the decreasing term policy and maintain good lifestyle habits, there is a very high chance that you will pay less during the 30-year term as compared to purchasing a whole life policy. However, you also understand that, by the end of that term, you may be unable to obtain new life insurance at affordable rates, particularly if you have begun developing health problems by that time. Therefore, it may be worth it for you to pay the additional $400-per-month premium for the whole life policy, in order to secure peace of mind that you will have life insurance coverage into your old age.

Another factor worth considering is the comparative interest rates of the two plans. Whereas the whole life policy allows you to build equity over time, the decreasing term policy provides a side fund with an expected 2% annual return. If, for example, the side fund offered a 10% interest rate instead, then that would naturally make it much more attractive.