What Is Term Life Insurance? What You Need To Know
Insurance is a much older concept than you think; in fact, there’s evidence showing that rudimentary forms of insurance existed as far back as ancient China!
Back then, merchants allegedly spread their wares among multiple ships to minimize the risk of loss; in other words, they didn’t put all their eggs in one basket.
It didn’t take long for other ancient societies to turn this practice of spreading risk into legitimate contracts.
The rest is history.
Ever since then, insurance grew in importance and complexity. Today, there’s insurance for everything:
- Health
- Auto
- Property/Casualty
- Mortgage
- Renter’s
- Travel
- Pet
And many more.
There’s one type of insurance that’s so prevalent that many people make a career out of selling it:
Life insurance.
Life Insurance: What Is It And Why Buy It?
Life insurance contracts involve three major parties:
- Insurance company – The company that sells you the policy
- Policyholder – The person who took out the policy
- Beneficiary(s) – Those who receive the insurance proceeds upon a qualifying event occurring.
Although there are a few types of life insurance (as we’ll get to in a minute), the general idea remains the same: to provide cash to beneficiaries in case the policyholder passes away.
Here’s how it works: you (the policyholder) make monthly premium payments to your life insurance provider, just like any other insurance policy.
Upon your death, a lump sum known as a “death benefit” is paid out to your beneficiaries so they can stay afloat if they were relying on your income.
In other words, life insurance protects your family’s finances in case you pass away too soon.
Types Of Life Insurance
There are a 2 main types of life insurance: Term and Permanent. Each one has a few variations. Although we’ll be discussing normal term life insurance in-depth, it’s important to know all of them.
Term Life Insurance
Term life insurance lasts for a set amount of time; your options are usually in increments of decades (10-year, 20-year, etc.).
Over the course of the “term”, you pay regular monthly premiums to your life insurance providers. If you die during the term, your beneficiaries receive the death benefit.
Otherwise, the policy terminates when the term ends and you don’t receive any money back in most cases.
However, a subset of term life insurance called Return of Premium (ROP) insurance does exist; it’s more expensive, but pays you back your premiums tax-free if you outlive the policy term.
Permanent Life Insurance
Permanent life insurance policies last for the remainder of the policyholder’s life. There are a few different kinds of permanent policies:
- Whole life – You make regular fixed payments for the rest of your life; in exchange, your beneficiaries are guaranteed the policy’s death benefit upon your death.
- Universal life – Much more flexible than whole life. After your first payment, you can adjust the payment size and schedule to fit your liking.
There are many different types of whole life, but most of their differences are based on how much you pay and when.
Both whole life and universal life have their pros and cons when compared against each other, but the one thing that separates them from term life insurance is their permanent status.
Pros of Term Life Insurance
Less Expensive
Term life insurance is much cheaper than any form of permanent life insurance since you’re putting your payout on the line.
From the insurance company’s perspective, there’s a chance you won’t die at all and so they make these policies a lot cheaper to accommodate the lower risk they bear.
Customizable Term Length
When shopping for term life insurance, you can make your policy as long or as short as you want.
But how is this better than having the guaranteed lifetime coverage that permanent life insurance provides?
Remember: permanent policies are much more expensive than term policies. If you have a good idea of how much longer you’ll be around, you can tailor the length of your policy term to that amount of time to save money and still guarantee your dependents will be able to survive financially without you.
For most, the extremely high cost of permanent insurance just doesn’t out weight the tiny bit of extra assurance that you’ll get paid.
Cons Of Term Life Insurance
No Guarantee Of Death Benefit
Term life insurance contracts are temporary; if you outlive the policy term, the policy terminates and you no longer have life insurance.
Unfortunately, this also means you won’t receive any death benefit.
Now, it’s all well and good that you didn’t die at all during the policy term. But if you pass away right after your contract ends, your family will be out of luck AND they won’t have access to the money you paid in premiums as that money now belongs to the insurance company.
As we mentioned earlier, there IS a type of term life insurance that returns your premiums if you outlive the contract.
But of course, they compensate by charging you higher premiums.
More convenience and security begets more cost.
No Cash Value
Permanent life insurance policies build what’s called a cash value. As you make payments, the insurance company puts a portion of each payment into high-interest bank savings account.
At first, it doesn’t do much as it’s only a portion of your premium.
But over time, your cash value continues to grow from both premium payments and interest/returns you earn on the increasing cash value.
This cash value can be thought of as equity: you can borrow against it, use it to negotiate a higher death benefit, receive it (minus fees) if you “surrender (aka cancel) your policy, and even pay your life insurance premiums once it’s earning enough return to cover them!
Sounds great, right?
Well, term policies don’t have a cash value. Your entire payment covers your premium.
If you think about it, it makes sense: term life insurance premiums can run you a few hundred a month, while permanent policies tend to cost in the thousands per month.
Permanent policy premium payments provide a lot more room for building up a cash value.
Who Should Get Term Life Insurance?
Based on it’s characteristics, term life insurance is best for young parents who also have young kids.
This may seem counter-intuitive since young people have many decades left to live, but let’s dive a bit deeper.
First, on young parents.
Old age isn’t the only cause of death; you never know if tomorrow is your last day on earth. Term life insurance might not last forever, but it covers enough “tomorrows” to make the purchase worthwhile for young parents.
If the policy-holding parent dies during the term, the beneficiaries can get by.
If the policy-holding parent doesn’t die during the policy term, then they’re glad to be alive AND they had the peace of mind that they’re family in case of the worst case would have been taken care of.
But why young children?
As horrible a situation as this might be, teenagers and young adults tend to be more able to find employment and support themselves to some degree. Young children obviously aren’t able to do that.
Add all that to the fact that term life insurance is several times less expensive than whole life insurance (most young people can’t afford to pay $2,000/month for life insurance), and young parents with young children appear to be prime candidates for term life insurance.
Life Insurance Considerations
Life insurance is not a simple field to navigate yourself, so here are some things to consider while shopping around.
Physical Health
Staying healthy pays off big when shopping for life insurance, and the reason should be obvious: the healthier you are, the less likely you’ll die and thus making the insurance company pay out the death benefit.
Different Offerings
As you know, there are many types of life insurance to fit many different situations. If you’ve determined you need life insurance, make sure to take stock of your situation to determine whether you want term, whole, universal, or a subset of one of those.
In addition, take as much time as you need to browse the marketplace. There are an untold amount of people/companies selling life insurance, so you have plenty of flexibility when looking for a policy.
The Amount You Need
A life insurance rule of thumb is to buy 10 times your salary’s worth of life insurance. You may need more though depending on the number of beneficiaries on your policy and their expected future expenses (such as children who will need to go to college).
Speaking of beneficiaries…
Who Should Be My Beneficiaries?
Technically, you can name almost anyone as the beneficiary of your policy. In addition, you can usually add multiple beneficiaries to divide the proceeds how you see fit.
Most of the time, people name their spouse as the primary beneficiary as they’ll be the one handling the finances upon the policyholder’s death. However, some name their young adult children as beneficiaries too.
But perhaps you’re single and thinking of the future. You could name friends, relatives, or even your favorite charity as your beneficiary
To make a long story short: choose beneficiaries based on who relies primarily on you in terms of finances.