If you look through a term life brochure, you’re likely to see the term modal factor. It’s one of those life insurance terms that is perplexing and sounds like it comes from a science fiction movie. It’s important to understand the term however since it can affect how much you pay for life insurance. Let’s take a quick look at modal factors.
Depending on the life insurance company, you typically have various options on how you can pay your life insurance premium and we’re not just talking about auto-deduction, credit card, or standard billing. You also have options on how often during a year you will pay your premium. When you run your term life insurance quote, the rates normally reflected there assume you are paying your premium on an annual basis. You may have options to pay the premium over shorter durations such as monthly, quarterly, bi-annually, etc. This is what dictates the modal factor.
The modal factor is usually a percentage. For example, it may look something like this:
Semi-annual = .51 (8.2% APR)
Quarterly = .26 (10.8% APR)
Monthly = .0875 (10.8% APR) Pre-arranged withdrawals only)
This essentially means that you will pay more per year if you pay at a smaller installment than annually. Let’s take an example. Let’s say your annual premium is $1000 (to make it easy). If you choose to pay semi-annually (every 6 months), then we would apply 51% of the $1000 annual charge. In this case, you would pay $510 twice during the year. This means you are paying a total of $1020 for the year for an additional premium of $20. This modal factor is essentially a 2% penalty for paying twice a year instead of annually. The penalty goes up for shorter durations. Taking our same example of $1000 annual premium, if we pay quarterly, then we would pay a 4% penalty (26%+26%+26%+26%). In this case, we are paying an additional $40 on the $1000 premium. The penalty for monthly is steeper. If we multiply the .0875 modal factor by 12, it amounts to a 5% extra premium. That means, we are paying $1050 versus the annual premium of $1000. Of course these shorter durations are not only easier on the pocketbook but can be more convenient when paid with automatic withdrawals or credit card debits. Why do you have to pay more via these modal factors for life insurance?
Keep in mind that life insurance is a pre-paid policy which means you are paying now for the next year (or quarter or 6 month depending on payment schedule). A big part of how a life insurance company functions is to take the premium now and invest part of it to offset future claim payments. The modal factors simply reflect the loss of income from investment that the carrier forgoes by premium not being received. For example, if you pay $1000 up front, the carrier can invest part of this to make an additional 4% conservative. If you pay twice a year, the carrier can only invest $500 for the first 6 months. To offset the 6 months investment income on the second payment, they charge you the modal factor. The monthly payment cycle means that they can only invest 1/12th of the premium amount for the first months and 2/12ths in month 2 etc. This figures into the 5% penalty in our example above.
Ultimately, it’s up to you and your comfort level. If you can financially manage it, you will pay less by paying the annual amount. You need to weigh this savings versus the convenience and budgeting ease of paying smaller amounts more frequently.