Most of us are familiar with health insurance, auto insurance, and homeowners or renters insurance. But how much do you know about life insurance? Despite the fact that it's one of the most important types of insurance to have, many Americans either have inadequate coverage or don't have coverage at all. Here, we'll review the importance of life insurance and walk you through the various types available -- namely, term life insurance versus different kinds of permanent life insurance. We'll also review what to look for in a policy and how much coverage to buy.
Why you need life insurance
Life insurance isn't just for the rich. Even if you're a low or average earner, you still need life insurance to protect your loved ones in the event you pass away sooner than expected.
If you're wondering whether you need life insurance, the question really boils down to whether your death will impact loved ones financially. If the answer is "yes," then you absolutely need a policy.
Keep in mind that you don't need to be earning money for your death to constitute a financial blow. Imagine you're a stay-at-home parent who watches the kids while your spouse works. If you were to die, your death would hurt your family financially, because they would need to pay for child care.
How life insurance works
When you buy life insurance, you're essentially signing a contract with a life insurance company. You agree to pay premiums (a fee for your policy) on a regular basis (often annually, though sometimes semiannually, quarterly, or monthly), and in return, your life insurance company agrees to pay a death benefit upon your passing.
The cost of your premiums will depend on a number of factors, including your age, health, and how large of a death benefit you're looking for. Once you have a policy in place, you'll need to designate beneficiaries to receive that death benefit, which can then be used for everything from funeral expenses to general bills.
How to apply for life insurance
Buying life insurance may seem like a daunting prospect initially, but it's actually quite simple. There are a couple of ways you can purchase life insurance. First, you can call up individual insurance companies and request quotes directly from them. You can also find an independent insurance agent who can review your options for coverage through various insurance companies. Keep in mind that these agents earn commissions for selling policies, so avoid agents who seem to be pushing the most expensive choices out there to pad their own wallets. If you have a financial advisor, he or she may be able to recommend someone.
It's a good idea to get multiple life insurance quotes so you can comparison-shop and see what premium rates you're presented with. Of course, you'll also need to decide how much coverage to buy and whether you want term life insurance versus permanent life insurance, but we'll discuss that in a bit.
You'll need to fill out a detailed application for life insurance that will then be reviewed by the issuing company in question. Be prepared to include a host of health-related information, which will then need to be verified by your insurance company for accuracy.
You'll also need to complete a medical exam before you can get approved for your policy. Often, an insurance company representative will come to your home to perform the exam, making it fairly convenient for you. During that exam, you can expect to have your weight and blood pressure checked. You'll also need your blood drawn so that it can be tested for factors that determine your eligibility for insurance, such as underlying diseases, cholesterol issues, and blood sugar problems.
It generally takes a number of weeks to process the results of your exam. Once that happens, your policy will be written up, at which point you'll sign some paperwork, submit your initial premium, and rest easy knowing that you now have coverage.
How much coverage do you need?
Figuring out how much life insurance to buy is tricky. The more coverage you get (meaning, the higher a death benefit your loved ones are entitled to), the costlier your premiums will be.
Many financial advisors historically recommended having enough life insurance to replace 10 times your salary. That advice, however, is a bit too simplistic, because it doesn't necessarily take all of your family's needs into account. For example, if you want enough life insurance to support your family but also pay off your mortgage or put your kids through college, then 10 times your salary may not cut it. Also, the 10-times-salary formula doesn't work for stay-at-home parents who earn no income, even though their passing would constitute a financial hardship.
A better bet, therefore, is to look at your income, debts, and financial goals, and then buy enough coverage to address all of those factors.
First, let's talk income. What you need to do here is decide how many years of income you'd need to cover if you were to pass. That might be 10 years' worth, or it might be a higher or lower number. For example, if your children are 10 and 12, you may want enough years' worth of income to pay their expenses through the end of college. But if your children are 18 and 20, you might get away with less coverage. Similarly, if your spouse never worked and is in his or her 40s, you probably want enough income to tide your spouse over until retirement, and you'll need to pay for it accordingly. But if your spouse is 59, you only have a few years before he or she is eligible for Social Security, in which case you may not need such a high death benefit.
Next, look at your debts -- especially your mortgage, if you have one. If you think you'd want the option to have your beneficiaries pay it off upon your passing, then factor that into your coverage.
Finally, think about your future financial goals and what they might cost. If you'd like your insurance policy to provide enough income to put your children through college and pay for their weddings, you'll need to account for that in your calculations. If those things aren't important to you, then you can opt for less coverage.
Once you've accounted for all of these costs, add them up. If you're a couple and one of you is a stay-at-home parent, be sure to factor the cost of child care into your calculation.
Let's say you and your spouse each earn $100,000 a year for a total of $200,000, and you want to replace 10 years' worth of combined income for a total of $2 million. Let's also say you want the option to pay off your $300,000 mortgage, give each of your two children $200,000 for college, and have $50,000 available for each to pay for a wedding. All told, you're potentially looking at $2.8 million in coverage.
That said, if you have assets, you can subtract that amount and get a lower policy. For example, if you're targeting $2.8 million but happen to have $300,000 in savings, you can land on $2.5 million instead.
Types of life insurance
Once you figure out how much of a death benefit you're looking to get, you'll need to decide which specific type of policy to buy. There are two main types of life insurance: term life insurance and permanent life insurance. Permanent life insurance then has its own unique subsets: whole life insurance, variable life insurance, universal life insurance, and variable universal life insurance. Permanent life insurance, across the board, is known to be much more expensive than term life, so that's something to consider as you explore your options.
Term life insurance
As the name implies, term life insurance provides coverage for a preset period of time, or term. If you get term insurance and die within that designated period, then your beneficiaries get the death benefit your policy entitles them to.
You have the option to choose how long of a term your insurance policy should cover, though common options include 10 years, 20 years, or 30 years. Generally speaking, if you're on the younger side (say, in your 20s or 30s), it's wise to opt for a longer term, whereas if you're older, you might get away with a shorter one. If you have children, make sure the term you select will cover them until they're old enough to work full-time and support themselves. For example, if you have a 4-year-old and a 2-year-old, then a 20-year term gives you coverage until your kids are 24 and 22, respectively. At that point, they should, in theory, be able to go out and earn their own living.
Because term life insurance runs out at some point, it's generally less expensive than permanent life insurance. Furthermore, with term life insurance, your premiums stay the same until your policy runs out.
On the other hand, term life insurance doesn't build any cash value, so once your policy runs out, it won't be worth anything. This isn't the case with permanent life insurance. As such, you may feel that by buying term life insurance, you'll end up throwing away your money if your death benefit is never paid out. Then again, not getting that death benefit means you didn't pass away during that time frame, so that's something to be grateful for.
Another downside of term insurance is that once your covered time period expires, your coverage goes away. As such, it can be challenging to determine just how much coverage you need, and some people make the mistake of buying limited coverage only to find they need more of it later on.
Here's how that might play out. Imagine you're a healthy 35-year-old and decide to buy coverage for a 20-year term. If, at age 53, you're diagnosed with an illness at the same time you realize you want to extend your coverage past its 20-year term, you risk getting denied or having your premiums climb substantially. Neither is ideal.
Whole life insurance
Unlike term life insurance, which covers a limited period of time, permanent insurance does not expire. There are different types of permanent life insurance, the most well-known being whole life insurance.
Whole life insurance is designed to cover you for the rest of your life, provided you keep paying your premiums -- which are fixed -- on schedule. Not only does whole life insurance provide a death benefit for your loved ones (which they get to collect tax-free), but it also accumulates a cash value.
As you pay your whole life insurance premiums, that money is divvied up. Some of it goes toward your death benefit, and the rest goes toward your policy's cash value so that it builds over time. Eventually, the cash value portion of your policy will actually represent your entire death benefit.
Your life insurance company will generally put that cash value portion in a high-yield savings accounts to grow that sum, but you won't pay taxes on any gains (in this case, interest) in that account year after year, kind of like a traditional 401(k) or IRA. Your whole life policy might also pay dividends, just like the dividends you'd get from holding certain stocks.
What good does that cash value portion do you? A lot, actually. You can take out a loan against that part of your policy, or even withdraw some of that cash to use -- though if you go that route, your death benefit will be reduced by the amount you withdraw. For example, if you have a $500,000 death benefit with a $200,000 cash value and you withdraw $100,000, your resulting death benefit will be $400,000. But what you get in return is more flexibility with your money.
In fact, one benefit of whole life insurance is that it's essentially a means of forced savings, and in any case, you'll get value from it in some shape or form. With whole life insurance, you also have the option to surrender your policy, in which case you get its accumulated cash value. However, you lose the death benefit you would've otherwise left to your heirs.
The primary downside to whole life insurance is its cost. Because you're getting a cash value out of your policy coupled with coverage for life, you're apt to pay considerably more than you would for a term life policy.
Variable life insurance
Variable life insurance is also permanent. It lasts your entire life, provided you pay your premiums, and it accumulates a cash value like whole life insurance.
The main difference, however, is that with variable life insurance, the cash value portion of your policy is invested in mutual funds with a variable growth rate that hinges on those funds' performance. As such, the cash value portion of your policy can actually lose value, but it can also potentially grow at a much higher rate than a whole life policy. Like whole life policies, variable policies get to grow on a tax-deferred basis.
One major drawback of variable life insurance is that your premiums can rise if your policy's investments perform poorly and your cash value drops. Further, in exchange for the potentially higher returns you'll get in your variable policy, you might be hit with investment fees that could eat away at your returns.
Universal life insurance
Universal life insurance is a common choice for group policies offered through workplaces. Like whole life insurance, universal life policies accrue a cash value, and interest is applied to that cash value to help it grow. That interest is guaranteed at a certain rate.
With universal life insurance, premiums are initially set up to cover more than cost of the insurance itself. The excess from those premiums is then allocated to the cash value portion of the policy.
The main difference between whole life insurance and universal life insurance is that with the latter, your premium costs can vary, because you can use the cash value portion of your account to pay some or all of your premiums. Further, some universal life policies allow you to increase or decrease your death benefit as wanted or needed.
Within the realm of universal life insurance is indexed universal life insurance. This product works similarly to regular universal life insurance, except its cash value component pays a return based on the performance of a market index, like the S&P 500. As such, you might get better growth on your cash value than with a regular universal life insurance plan. The flip side, however, is that if the market underperforms, you wind up with lower returns. And since your insurance company gets to keep a portion of your gains, your actual returns will be lower than what the index in question is paying.
Variable universal life insurance
Variable universal life insurance is similar to universal life insurance, but instead of earning a guaranteed interest rate on the cash value component of your account, you get the option to put a portion, or all, of that cash value into different investment funds. As such, you can lock in a fixed interest rate on some of that cash value but invest another part of it for higher growth.
The benefits of a variable universal life policy are similar to those of a universal life policy: You get flexibility with your premium payments, and there's the possibility to earn higher returns compared to what you'd get from other types of permanent life insurance. You also get to control the cash value portion of your account and invest it based on your personal appetite for risk.
On the other hand, you may take on more investment risk with a variable universal life policy and wind up decreasing your cash value as a result. You may also pay higher fees, due in part to the investments you choose.
Which type of life insurance policy is best for you?
Navigating your life insurance options isn't easy. If you're torn between the aforementioned choices, try asking yourself the following:
- How much can I afford to pay in premiums? You may find that permanent life insurance is out of your financial reach, whereas term life insurance is far more reasonable for you.
- Am I a good saver, or do I need a vehicle that will essentially force me to put money aside? When you buy term life insurance, you don't get money out of that policy unless you die -- and you don't want to sit around hoping for your own premature death to reap the benefits of your policy. When you buy permanent life insurance, you can use it as protection for your loved ones as well as a savings vehicle.
- How complicated a policy am I willing to sign up for? Term life policies are generally less complex than permanent life policies, and within the realm of permanent insurance, whole life policies are generally the most straightforward. If you'd rather keep things simple, you might opt for term or whole life coverage.
- How much peace of mind am I looking for? Term life insurance doesn't cover you for life; it only covers you for a predetermined period of life. If you happen to pass away the day after your policy ends, your loved ones are out of luck. With permanent life insurance, you're covered for good, and that may help you sleep better at night.
No matter which type of life insurance you land on, and how much coverage you decide to buy yourself, make sure you understand exactly what you're signing up for. At the same time, don't drag your feet when it comes to life insurance. The last thing you want to do is put off life insurance and land in a situation where you pass suddenly and your family is left in the lurch. While working those premium costs into your budget might require some effort on your part, consider it a worthwhile investment in your loved ones' well-being.