What Is Term Life Insurance?
You’ve heard you should get life insurance, and you’ve been putting it off forever (we’ve all been there). You’ve also heard that term life insurance is the best option, but you’re not sure what it is.
Don’t worry. It’s not as complicated as you might think. We’ll break down everything you need to know about term life insurance so you can protect your family and finally remove “buy life insurance” from your to-do list.
Let’s dig in!
- What Is Term Life Insurance?
- How Does Term Life Insurance Work?
- Types of Term Life Insurance
- What Happens at the End of Term Life Insurance?
- Term Life Insurance vs. Whole Life Insurance
- What Are the Benefits of Term Life Insurance?
- How Much Does Term Life Insurance Cost?
- How to Buy Term Life Insurance
1. What Is Term Life Insurance?
Life insurance is simply a contract between you and an insurance company. You pay them a monthly premium, and if you die, the insurance company pays a specific amount to whoever you choose.
Compare Term Life Insurance Quotes
Now let’s look at a type of life insurance called term life insurance (aka pure life insurance) that guarantees a death benefit if you (the insured) die during a period of time you specify (the term). If you die after the term is over, the insurance company doesn’t pay. Pretty simple.
Another important thing to know about term life insurance is that it has no cash value like a whole life insurance policy. And that’s actually what makes term life insurance a much better deal than whole life. All you’re paying for is life insurance—not some wonky cash value account that grows slowly (like over your entire life). And you can use the savings to invest and build real wealth. (More on all that a little later.)
2. How Does Term Life Insurance Work?
So, how does term life insurance work, exactly?
For starters, the insurance company looks at your age, health, death benefit amount and term length to calculate the cost of your policy. Then you make premium payments for the length of the policy.
Take Steve, for example—a healthy, nonsmoking 30-year-old who makes $50,000 a year. Steve’s death benefit is $500,000 because you need coverage that’s 10–12 times your yearly income. His term length is 20 years.
If Steve dies before his 20-year term is over, the $500,000 (his term life insurance benefit) will go to his beneficiaries (he named his wife and two kids). If he’s alive when his term life policy expires, Steve could renew it, but the premiums will be higher because he’ll be older and more expensive to insure.
3. Types of Term Life Insurance
Okay, so here’s where most people want to check out because, well . . . insurance. But as you look into term life insurance, you’ll definitely want to understand the different types:
Level Premium
Level premium (aka level term insurance) keeps your premiums level based on the length of your term (we recommend a term of 15–20 years). It’s the simplest form of life insurance because once you have it, the premium and death benefit amount don’t change.
That’s a nice feeling, isn’t it? This is the main reason Dave recommends term life insurance level premium policies. You know exactly how much it’s going to cost every time your premium is due, and you can work it into your budget. Could insurance really be this easy? Yes!
Increasing (Annual Renewable)
This type of policy renews every year, and the premium amount increases annually as you age until the term ends. Exactly how much the premium increases is determined by the insurance company when they measure your risk every year at renewal time.
While costs for increasing term life insurance can seem cheap during the early years of the plan, the premiums will increase over time and turn out to be higher than if you’d opted for a simple level premium policy.
Decreasing
A decreasing term policy is one where the payout decreases over time as your mortgage (or other type of loan) goes down—the payout and your loan amount drop together. The thought is that you don’t need as much of a death benefit if you’re paying down the loan—usually your mortgage—linked to the policy.
Premiums usually don’t change, so you end up paying the same every month but with the added feature of a decreasing payout. We don’t recommend this type of term life insurance.
Return of Premium
This looks good on paper since it’s supposed to give you back the cost of the policy if you survive through the end of the term (and we’re hoping you do!).
You get your premium payments back, but premiums for this type of term life insurance are much higher in the first place. We’re talking 30–40% higher than a level premium. In the end, it’s not worth it since you’re paying more up front.
Guaranteed or Simplified
A guaranteed or simplified term life insurance policy is one you can get without having to mess with a medical exam. You may just have to fill out a medical questionnaire rather than get poked and prodded. And some no medical exam policies have become very affordable, so they’re a good option.
Convertible
A convertible term life insurance policy is one that lets you convert term life to whole life down the line. But don’t do it! Your premium will jump way up when it comes time to convert. Some people might convert if they’re coming toward the end of their policy and have a terminal illness, but that’s a rare example.
Group
Your employer might offer group term life insurance as a benefit to their employees. They might even pay the whole premium in some cases. Either way, it’s cheap. We’ll always recommend you take the free option. But if you have to pay for your group plan, compare it closely to what you can get on your own before you chip in.
Payouts for group term life insurance are usually a lot less than a term life policy you take out on your own, so be sure to check the death benefit. And remember that if you change jobs, the insurance doesn’t go with you.
4. What Happens at the End of Term Life Insurance?
If your term life insurance policy is about to expire, you could renew it for another term depending on your age and life circumstances. Even if you have a level term plan, your premium rate will go up when you renew because you’ll be older and more expensive to insure (unless your name is Benjamin Button). There’s also a chance your premiums could go down if you choose a lower death benefit.
But you should ultimately shoot for being self-insured by paying off your debt, saving up an emergency fund, and building a good-sized retirement nest egg by the time your policy expires. It’s easier than you think! If you put 15% of your household income toward investing, you won’t need the death benefit by the time your term life plan ends because you’ll have made a pretty penny in investments.
5. Term Life Insurance vs. Whole Life Insurance
Whole life insurance (aka permanent life insurance) is in place for your whole life (and we hope that’s into your 80s and beyond!). But that’s a lot of premiums to pay—and high ones at that!
Why are whole life premiums so high? Because whole life insurance tries to act like a savings or investment fund (along with others in the cash value insurance family like universal life insurance).
Part of the sales pitch for cash value types of insurance is that they’ll help you build up an investment that could be tapped further down the line. Here’s how it’s supposed to work: You overpay in the early years to build up your cash value. Then as you get older and your premiums go up, you use your cash value to help pay for your insurance. In reality though, whole life sucks compared to term life when it comes to growing your money.
Let’s go back to our good friend Steve. He likes to dabble in the stock market, but his insurance agent says if he goes with whole life insurance, his premium will cover his life insurance policy and include investing.
What the agent doesn’t tell Steve is the growth of the cash value in a whole life policy is awful. He’d be way better off going with term life and investing the money he’ll save on the premium into good growth stock mutual funds. That’s because the rates of return for whole life insurance policies are really low compared to the rate of return for mutual funds.
Think of whole life policies as the timeshares of the life insurance industry—a scam to be avoided!
6. What Are the Benefits of Term Life Insurance?
Getting a term life insurance policy may be one of the smartest insurance decisions you can make. Here are three of the top benefits:
Protection for Your Family
If you and your spouse have young kids, term life insurance is the best way to protect them if something were to happen to you (God forbid). You’ll sleep better knowing those little ones will be taken care of, along with your spouse.
Best Value
Term life insurance is some of the cheapest insurance out there. It gives you the best bang for your buck, by far.
Expiration Date
Term life has a set time it expires, so you’re only paying for it for a specific amount of time. And you won’t be wasting money later in life on monthly premiums when you really don’t need the protection anymore.
7. How Much Does Term Life Insurance Cost?
Your age and your health are two of the biggest factors that affect the cost of term life insurance. Insurance companies also consider other factors when tallying your premium, including:
• Age
• Gender
• Length of term
• Death benefit amount
• Personal and family medical history
• Weight
• Tobacco use
To find out what your term life insurance cost would be, check out our free estimator tool.
8. How to Buy Term Life Insurance
There are a couple things to keep in mind as you think about getting a rock-solid term life policy in place. We’ll unpack how to get life insurance, specifically term life, so you can know what to expect. These tips will also prevent you from making some common mistakes when setting up your policy.
It’s also a good idea to check with your employer to see if they offer a group term life insurance policy. Employer policies usually don’t cover all your needs, but they can get you partway there.
Here are the essentials for getting term life insurance:
Submit Your Application
After you’ve gotten your quotes and picked the company you want to use, the first step is to actually apply. Depending on your situation, the insurance carrier will look into how much of a risk it would be for them to insure you (technically called an underwriting process). Sometimes a medical exam is also required, but like we mentioned earlier, some companies offer policies that don’t require a medical exam.
Pick the Life Insurance Term Length
We recommend buying a term policy that lasts 15–20 years. That’s because if you have young children now, they’ll be out of school and on their own by the time the policy ends. So, the only coverage you really need is during those 15–20 years in between—when they’re fully dependent on your income. And if you don’t have kids (or they’re grown up), that 15–20 years gives you plenty of time to become self-insured (more on that below) and provide for your spouse if something happens to you.
Choose Your Term Life Insurance Payout Amount
Here comes the math. (Don’t worry, it’s not calculus or anything.) Your death benefit needs to be 10 to 12 times your annual income. So just take your annual income and multiply it by 10–12 to figure out how much money your family would need if you died.
The goal is for your family to be able to invest the death benefit in good growth stock mutual funds averaging 10–12% growth each year. That way your family can use that growth to replace your income without having to touch the original investment.
So, here’s the equation: If you make $80,000 a year, multiplied by 10, you’d want a death benefit of at least $800,000.
Name Your Beneficiaries
Now it’s time to name your beneficiaries—the ones who will receive the money if you die. And don’t forget to name a contingent beneficiary. This person would receive the payout if something ever happened to you and the primary beneficiary. It’s kind of like a back-up plan for your back-up plan.
The Bottom Line
To sum it all up, we recommend level premium term life insurance with coverage that’s 10–12 times your income and a term that’s 15–20 years in length.
Remember, life insurance has one job: to replace your income if you die. It’s there to provide for your loved ones, not to make them rich. If you’re in the market for new life insurance or want to talk to an expert, we recommend RamseyTrusted partner Zander Insurance.
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