If you want to ensure that your family is protected when you pass on, life insurance is essential. Life insurance provides your beneficiaries with money that can be used to supply the loss of your ability to make money due to death. For those looking to receive a larger amount of coverage for an affordable price, term life insurance is often preferred. Here is what you need to know about term life insurance.
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What is Term Life Insurance?
Life insurance generally falls into two categories: Insurance that lasts your entire life (e.g., permanent life or whole life), as long as you are current on the premiums, and insurance that only covers you for a specific time period. Insurance that only covers you for a specific time period is known as term life insurance.
Term life insurance is only good for a specified amount of time, known, unsurprisingly, as the term. You can usually choose a term of between five and 40 years for your coverage. You make premium payments during that time, and if you die within the term, your beneficiaries receive the pay out. However, if you outlive the term, you no longer have coverage (unless you renew), and you have paid all those premiums for nothing.
Permanent Life Insurance
Permanent life insurance, on the other hand, lasts your entire life, no matter how long you live. So, whenever you die, your beneficiaries receive the payout — as long as you are up-to-date on your premium payments. Because permanent life insurance isn’t limited by time, it costs a lot more, though. Therefore, you can usually receive a much larger amount of coverage by paying a smaller premium if you are willing to use term life insurance.
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Convertible Term Life Insurance
One option is to pay for convertible term life insurance. This type of term life insurance comes with an option to convert to permanent life insurance at some point before the term ends. One of the advantages of convertible term life is that it prevents you from having to re-apply for life insurance coverage later on. This can be an advantage, since the older you are, the more you are likely to pay when you get a new insurance policy.
In many cases, a convertible term life policy has a slightly higher premium than a regular term life policy. However, if convert to a permanent policy later on, under the terms of your convertible contract, the premiums could be raised. However, many people are in a better position to afford these higher premiums on the permanent insurance later on. This means that convertible term life can work well for young families who want cheap coverage now, but want the option to convert to a permanent policy that covers until the end of life — and might even build cash value. A reasonably-priced convertible term life policy can help you keep you insurance options open.
Pros and Cons of Term Life Insurance
Buy More Coverage for Less
The biggest advantage to term life insurance is that you can buy more coverage for less. It’s possible to buy enough coverage to ensure that your family can live comfortably for years after you have passed on when you buy term life insurance. Permanent life insurance policies are much more expensive, and getting affordable coverage is more difficult.
Invest the Difference
Many people also like term life insurance policies because they have more money to invest. Instead of paying a higher premium, you can purchase adequate term life insurance, and then invest the difference between the term life premium and what you would have paid with permanent life insurance. If you choose your investment wisely, and if the market performs well over time, you could come out ahead by the end of your life insurance term, and have enough money so that it doesn’t matter that you no longer have coverage.
The flip side, of course, is that you might not make any money by investing the difference, and you might even lose money. With a permanent life insurance policy that is indexed, and comes with a guaranteed rate of return for building cash value, you are protected to some degree from the vagaries of the market. Weigh your options carefully when making this decision, although you might be better off not thinking about life insurance as an investment.
Lose Your Premiums if You Outlive the Term
One of disadvantages, though, is that, in many cases you lose your premiums if you outlive the term. With permanent life insurance, you usually build cash value, and you can cash in the policy at some point and recoup some of what you have paid in premiums. On top of that, a permanent life insurance policy with cash value can be borrowed against in an emergency situation. With term life insurance, you pay the premiums, and, if you live, it feels like a bit of a waste of money.
A return of premium term life policy can help offset this disadvantage. If you live to the end of the term, the insurance company returns part — or even all — of what you paid in. The premiums are a little bit higher on these policies so that insurance companies can make money investing the difference between the policy costs so that they are protected when they have to return your money.
How Much Term Life Insurance Coverage Do You Need?
There are different rules of thumb when it comes to figuring out how much life insurance you need.
Annual Income and Multiply by 10
The first rule of thumb is rather straightforward: Simply take your annual income and multiply it by 10. If you make $50,000 a year, you should get at least $500,000 worth of term life insurance coverage.
The 4% Withdrawal Rule (Multiply by 25)
Other ways of figuring your life insurance needs are a little more nuanced. One technique is assume that your family will put the payout from the policy into an investment portfolio of some kind. The 4% withdrawal rule of thumb is used to determine how much is needed. If your family needs $50,000 to replace your income, they will need $1.25 million in capital. With that lump sum put into an account, it is theoretically possible, according to the rule of thumb, for $50,000 to be withdrawn from the portfolio each year and the money should last indefinitely.
Total Expense Method
Another popular way to determine how much life insurance you need is to base it on your current expenses. Add up how much consumer, student and mortgage debt you have. Then, add in how much you spend each year on living expenses like bills, food, clothes and insurance premiums, multiplied by how many years your family will need the money after you are gone. Many people base the time the family needs the money on how long the youngest will be living at home. If you are a growing family, with a newborn, you might want to get 20-year term life coverage.
An example of this tailored approach is as follows:
- $200,000 mortgage
- $8,000 car loan
- $30,000 student loans
- $5,000 credit card debt
- $35,000 in household expenses x 20 years = $700,000
Added all up, the total comes to $943,000. You can modify the coverage by considering whether or not you want the life insurance pay out to cover your kids’ college costs after you are gone (which could boost the coverage amount considerably). You can also include the cost of a funeral in your term life insurance calculations.
Other Factors to Consider
You should also consider other factors, such as whether or not your spouse will be able to work after you are gone, or whether some items, such as cooking, babysitting and house cleaning will need to be performed by someone outside the family when the person who does these things dies.
Deciding how long of a term to get can be helpful as well. In many cases, you should get term life coverage that will at least get you to the point at which most of your dependents no longer need to be supported financially.
Choosing a Life Insurance Provider
Financial Health of the Life Insurance Company
Once you have decided how much life insurance is appropriate for your situation and your family, it’s time to purchase a policy. However, you need to be careful. While some states have guarantee funds that can help you recover if the life insurance company fails, not all states have these — and your reimbursement might be capped. If your life insurance company fails, you are out the premiums, and you don’t have coverage.
Instead, it’s better to do research into the company you purchase your life insurance policy from. You can check into a company’s rating by agencies like Fitch, Moody’s and Standard and Poor’s. These companies rate the health of other companies, including life insurance companies. While a financial health rating isn’t a sure indication that the life insurance company will remain in business, it can be one indication of the health of the company.
Customer Reviews
You should also look for reviews online. Find out what others are saying about the company, including whether or not it is difficult to receive payouts that are owed to beneficiaries. Find out about the customer service record of the life insurance company, so that you understand what type of company you are working with. If there are a number of red flags, avoid that life insurance company — even if the premiums are low.
Price Comparison Shopping
Now that you have a good idea of which companies have the financial strength and customer service to satisfy your requirement, it is time to look for the one that is affordable and fits into your budget. You can contact each of these insurance companies individually, or you can use sites free comparison sites like InsureMe.com to save you some times. Here is an article on how to find the best insurance price quotes and where to find life insurance providers.
The Bottom Line
Your individual situation dictates what kind of life insurance is best for you, and how much coverage to get. Carefully consider your financial situation, and what you want to leave for your family, as you make this decision.
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Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own blog at Miranda Marquit.
Thank you for this excellent resource. I am in the process of buying a life insurance and this article assured me that my decision to choose term over permanent is the right one. Now it’s a matter of going through other steps.
I’m currently looking at renewing my life insurance so this info is really really useful. I didn’t actually realise that there were so many different options to be honest, but this is an excellent summary
For 99% of people Term Life is the best way to go. At the end of 20 or 30 years, there is a good chance that you will be self-insured, meaning you have enough to retire and pay for your expenses…etc. Also, the best rates for insurance are for non-smokers and those in good health.
Agree on term life insurance being the way to go. Just make sure you pass that physical so the rates stay low.
In Canada, many insurance companies offer term insurance plans to age 100, some of them offering 20-year pay periods with return of premium. The best way to approach purchasing insurance is to speak with a Certified Financial Planner who can offer you insurance options from competing companies and determine both your short term and long term needs as the amount of insurance you need in retirement is most probably not the amount of insurance you need when you have young children and a mortgage. And then there are those who wish to use insurance to leave a legacy, either for… Read more »
Thanks for the article. Calling an insurance broker about my term life insurance was on my to-do list for this week and knowing the different between all the options really helps.
Mark – (not sure if you’ll read this) – Do you think an insurance broker could get just as good of rates if you know the $$ value that you want/neeed?
Hi Jeff, I think anyone in the industry should be able to get you good rates if you know the amount of insurance you require. That person (imho) should discuss with you what your needs are to determine or confirm the amount of insurance you need and then be able to check at least three different companies to evaluate the best price. Keep in mind that there shouldn’t be too much price variation between good companies and sometimes the least expensive premium might not be the best if that company is more difficult to work with when it comes to… Read more »
This brings up some very good points. The best thing you can be when its time to decide on polices is educated. I encourage everyone to ask their agents any, and all questions that they may have about life insurance and the amount of coverage they need. I just recently bought some term-life insurance from Prudential. It was easy and painless because I did some research before hand, and I encourage everyone else to do the same as well! Great article, thanks!