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Life insurance provides important financial protection for loved ones in case of the policyholder's death. Term life insurance is a simple form of insurance protection that remains in effect for a set amount of time. This guide will explain how term life insurance works as well as its benefits.
What is term life insurance?
A term life insurance policy is a type of insurance in effect for a limited time, such as 20 or 30 years. If the policyholder dies of a covered cause while coverage is in effect, the insurer pays out a death benefit. If a policyholder remains alive, the policy ends and no benefit is paid out.
Term life insurance is affordable. Premiums can be very low, especially if it is purchased by young people. It provides important protection. Surviving family members can avoid a decline in their quality of life caused by the loss of the deceased person's income.
How does term life insurance work
Consumers can purchase a term life insurance policy from a number of insurers. Many companies require a medical exam, but not all do. Policyholders decide how much coverage they want. This can range from a small death benefit worth a few thousand dollars to cover funeral expenses up to policies with a death benefit of $1 million or more.
Insurers price premiums based on the likelihood the policyholder will die during the coverage term. Premiums are often affordable, especially if the policy is purchased by someone young and healthy. The policyholder chooses one or more beneficiaries to receive a death benefit if they die during the term. The larger the death benefit, the higher the premiums.
If the policyholder dies of a covered cause during the coverage term, the beneficiary receives the death benefit. This money is generally paid tax free to beneficiaries.
Types of term life insurance
There are many types of term life insurance. Here are some of the most common types of term life insurance policies you may encounter.
Level term life insurance
Level term life insurance is very common. With this type of policy, the premiums and death benefit remain level over the life of the loan; neither changes. Typically, level term policies remain in effect for five to 30 years. The policyholder pays the same premiums the entire time. Premiums are typically affordable. At the end of the policy term, the policy expires with no guaranteed option to renew.
Convertible term life insurance
Convertible term life insurance can be converted into whole life insurance if the policyholder desires, so those who want to maintain insurance coverage for the long term have the option to do so. Convertible term premiums can become much more expensive if the term life policy is converted to a whole life policy.
Increasing term life insurance
Increasing term life insurance gives the policyholder the option to increase the death benefit over time. Switching to higher coverage comes at an additional cost. But policyholders don't have to worry that health conditions will prevent buying more coverage later.
Term life insurance vs. whole life
There are huge differences between term vs. whole life insurance in terms of cost, purpose, and coverage.
Term life policies are in effect for a limited time. If a policyholder doesn't die during the term, no death benefit is paid out. Premiums are based on the cost of insurance during the term. Term life insurance is generally much more affordable than whole life coverage. However, term life policies do not accrue cash value. They cannot be cashed in or sold, and they aren't an investment.
Whole life policies can remain in effect indefinitely. They are more expensive. But a death benefit is always payable, as long as the policy remains active. This can be ideal for someone who will always need coverage -- for example, a parent with a disabled child. Whole life policies can accrue a cash value. They can be used as an investment. It's possible to cash them in, and policyholders can also borrow against the value of their policy.
Term life insurance vs. permanent life
Term life insurance provides protection for a limited time. Permanent life insurance provides protection indefinitely.
Whole life insurance is the most common type of permanent life insurance. Universal life insurance is another type of permanent life insurance. Universal life policies also offer lifetime protection, but there is more flexibility in terms of premiums and death benefits. For example, you can sometimes use the cash value of your policy to pay premiums, and you have the option to increase the death benefit.
How much term life insurance do you need?
You may want to consider buying enough term life insurance to provide for the needs of your loved ones if you pass away. A simple rule of thumb is to multiply annual income by 10, so a person who makes $50,000 would need a $500,000 death benefit.
However, this may not take individual needs into account. Instead, some people prefer to make a personalized calculation using the DIME Formula. This involves adding up:
- Debt: Total outstanding bills plus the cost of final expenses
- Income: The number of years of income to replace
- Mortgage: The outstanding balance of a home mortgage
- Education: The estimated future education costs for children
Who should get term life insurance?
Everyone who has people depending on them -- via income or services provided -- should consider purchasing term life insurance.
For example, a stay-at-home parent would need life insurance because the work they do provides value, though not direct income. Someone who cares for aging parents would also need term life insurance, as would a family's income provider.
How long do you need term life insurance?
Term life insurance should remain in effect until no one is dependent upon the policyholder's income or services.
At some point, for example, people usually retire, and their loved ones would no longer take a direct financial hit if they passed away. At this point, insurance coverage is not vital.
Term life insurance rates
Term life insurance rates are determined by the risk associated with insuring an individual policyholder. Rates are calculated based on:
- The policyholder's age
- The policyholder's health status
- The number of years the policy is in effect
- The amount of the death benefit
Longer term policies, policies purchased by older or sicker people, and policies with high death benefits are priced higher, because there's more risk to an insurer. Term life insurance premiums for a young non-smoker could be as low as $30 per month, while those for a 60-year-old smoker could cost over $1,000 per month.
Term life insurance rates by age
Term life insurance rates increase for older policyholders who purchase coverage. For example, a policyholder who purchases coverage at age 25 could pay around 5% less than someone who purchases coverage at age 30.
However, a policyholder who purchases level term life insurance does not see premiums rise once they have coverage in place. This is why it is generally best for consumers to get protection in place while they are young and healthy.
Term life insurance calculator
Many life insurers offer a term life insurance calculator to help policyholders determine the amount of coverage they need, as well as the costs. A term life insurance calculator can make it easier to shop for the right insurance protection.
Best term life insurance companies
The best term life insurance is determined by each individual's situation. For example, some insurers are better for people with pre-existing medical conditions, while others are a good fit for a young, healthy person.
To find the best life insurance companies overall, shop around with insurance providers and get multiple quotes. Consider starting with The Ascent's picks for the best insurers, including:
- Bestow
- Northwestern Mutual
- State Farm
- Liberty Mutual
- New York Life Insurance
- Principal Financial
Advantages of term life insurance
Term life insurance has several benefits:
- It provides protection during the years when coverage is needed.
- It is affordable, with premiums sometimes starting as low as $30 per month
- It can provide important protection for loved ones in case of an untimely death
Disadvantages of term life insurance
It also has some disadvantages:
- Term life insurance policies do not remain in effect indefinitely. If a policyholder doesn't die during the term, no death benefit is paid out.
- Unlike whole life policies, term life insurance policies do not have an investment component, or accrue cash value.
Want to learn more? Check out The Ascent's complete guide to who needs life insurance.
FAQs
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Term life insurance policies cannot be cashed out. They do not accrue cash value. Whole life insurance policies do. However, whole life insurance policies are more expensive.
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Policyholders generally do not get back their money at the end of the term after purchasing term life insurance. If they do not pass away during the term, no death benefit is paid out and premiums are not returned.
However, some insurers offer a return of premium rider. This enables purchasing additional coverage. For an extra fee, a return of premium rider guarantees the return of premiums paid if the policyholder does not die during the term of coverage.
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If a policyholder outlives a term life insurance policy, they no longer have coverage. The policy terminates and no death benefit is paid out.
If the policyholder has a return of premium rider, premiums are returned. If the policyholder has a convertible policy, they may be able to convert their coverage to a whole life policy if they want additional protection.
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If a policyholder dies while their term life insurance is in effect, the death benefit should pay out, as long as they died of a covered cause. The amount of death benefits the policyholder purchased is paid out to the beneficiaries the policyholder designated when buying coverage.
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It is less expensive to buy term life insurance when you're young and healthy. This also helps avoid the risk of cost increases or disqualification if a policyholder develops certain health conditions.
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Usually, it is possible to cancel term life insurance. This can be done by contacting the insurer and discontinuing the policy. A policy is also cancelled if the policyholder stops paying premiums.
When a policy is cancelled, it no longer provides coverage. There is no guarantee that it will be possible to purchase a similar policy for a comparable price in the future.
Our Insurance Expert
Christy Bieber is a full-time personal finance and legal writer with more than a decade of experience. She has a JD from UCLA as well as a degree in English, Media and Communications with a Certificate in Business Management from the University of Rochester. In addition to writing for The Ascent and The Motley Fool, her work has also been featured regularly on MSN Money, CNBC, and USA Today. She also ghost writes textbooks, serves as a subject matter expert for online course design, and is a former college instructor.
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