What Is Term Life Insurance and How Does It Work?

As the name implies, term life insurance covers you for a set period. Typical terms are 10, 15 20 or 30 year periods. During that time, you will pay monthly premiums for a specified amount of coverage, aka death benefit. If you die during that term, the life insurance company will pay out your death benefit to your beneficiary(s).

If you do not die during that term, your death benefit will not be paid out and your coverage will end. You can buy another term policy if you desire or convert your term policy into a permanent policy if available. For example, let's say that you have young children who depend on you and decide to buy a 20 year term policy for $1 million to protect them.

God forbid you die in the next 20 years, your policy would pay out $1 million to your beneficiary(s) which might be your spouse or your children depending how you set up the policy. The death benefit passes tax free to your beneficiary(s) meaning they would not owe any taxes on the $1 million. If you are alive after 20 years, your coverage would end.

Outside of getting life insurance through your employer, term life insurance is the most affordable way to get coverage. Most term life insurance policies do not pay out which means insurance companies are able to charge lower premiums for coverage.

1) Level term policy - As the name implies this type of term life insurance has level premiums which means you will pay the same price for coverage over the term. Most term life insurance is a level term policy. The death benefit is also fixed.

2) Return of premium term policy - Select insurers, such as State Farm, offer what is called a return of premium life insurance policy. The policy works in the same way as a level term policy, but with one caveat. If you are still alive after your term is up, you get all of your premiums back.

For example, let's say that you bought a return of premium term policy with a 20 year term that cost $75 per month. If you were still alive in 20 years, you would get $18,000 back (the amount you paid into the policy). Return of premium policies are often more expensive than a standard level term policy.

3) Decreasing term policy - A decreasing term policy has a death benefit that decreases over time according to a predetermined schedule. The idea is to have enough coverage for a major expense, such as a mortgage, that you are paying off over time.

The premiums of a decreasing term policy are fixed. It is usually a better idea to opt for a level term policy over a decreasing term policy as your death benefit coverage stays fixed. It will give you more bang for your buck.  

1) Affordable - Term life insurance is very affordable if you are young and healthy. The exact amount you will pay will vary based upon a variety of factors which we will look at later. If your goal is simply to get coverage for the cheapest price, term life insurance is usually the way to go.

2) Temporary protection - If you have young children, you might only need to cover them until they are old enough to rely on themselves. A term policy will allow you to buy coverage to protect you when your beneficiary(s) are most reliant on you.

3) Potentially large death benefit - Since term life insurance is so affordable, there is a good chance that you can purchase a policy that has a large death benefit. A larger death benefit can make a huge difference to your beneficiary(s) if you were to die.

4) Convertible - Many term life insurance policies allow you to convert the policy to a permanent life insurance policy. Permanent life insurance policies cover you for your entire life. Having a term policy in place gives you the flexibility later down the line to convert the policy if it makes sense for you to do so.

1) No permanent coverage - In all likelihood, you will not use a term policy if you buy one. This does not mean a term life insurance policy is a waste of money. If you were one of the few people that died early, your beneficiary(s) would be grateful you had it.

The point here is that you can contrast term life insurance with a permanent life insurance policy. A permanent life insurance policy provides coverage for your entire life. This means that it is a guarantee that a death benefit will be paid out to your beneficiary(s).

2) No cash value - Term life insurance only offers a death benefit. Permanent policies, such as whole life insurance, also offer a cash value component. With a permanent policy, part of your money goes into a cash value account that earns a guaranteed rate of return from the insurer.

This cash value can be used in a variety of ways while you are still alive. Permanent life insurance policies are more complex but can be a nice addition to a well rounded financial plan. If you want your life insurance to provide more than just a death benefit, you can consider a permanent life insurance policy.

3) Premiums increase if you renew - If you bought a 10 year term policy and decided to renew it at the end of the term for another 10 year term, your premiums would increase. Life insurance prices are partially based on your age and health. If you want to lock in level premiums for life, a permanent life insurance policy can be a better option.  

The average cost for a 20 year term life insurance policy with a $1 million death benefit is around $43 per month for a healthy non-smoker 30 year old female and $54 per month for a healthy non-smoker 30 year old male. However, the exact amount of money you will pay will vary based upon the following factors.

1) Age - The younger you are, the cheaper your premiums tend to be as you are less likely to die. A healthy 20 year old has much longer to live than a healthy 60 year old. If you want a whole life insurance policy, it is best to buy one when you are young to lock in an affordable premium.

2) Gender - Life insurance is cheaper for women than it is for men.

3) Health - Your health plays a huge factor in the price of your life insurance as better health will get you into a better risk class rating. Life insurance companies will look at your height and weight, and any pre-existing medical conditions that you have or previously had. The healthier you are, the less you pay.

4) Family medical history - In addition to your own health, life insurance companies will also look at the medical history of your family. If you have had family members that have died from cancer or heart disease, you could end up paying a higher premium.

5) Smoking/tobacco use - If you smoke, chew tobacco, use a pipe, vape, or use e-cigarettes, you will pay a higher premium for coverage. Life expectancy is 10 years shorter for smokers than it is for non-smokers. Life insurance companies charge more to take on the risk of insuring you if you smoke or use tobacco.

6) Coverage amount - The more coverage you have, the higher your premiums will be. $1 million of coverage will obviously cost more than $500,000 of coverage.

7) Hobbies - Dangerous hobbies can cause the price of your premiums to increase. Any activity than a life insurance company believes will increase your chance of death is more of a risk to them and you will be charged more for coverage. Think of things like scuba diving, car racing, hang gliding, etc.

8) Occupation - If your work increases the chance of death, you will be charged more for coverage. An office job won't affect this, but industries such as construction, roofing, certain types of police work, firefighting and others can cause your premiums to increase.

9) Driving and criminal record - If you have a reckless driving record with DUIs, a suspended license or frequent traffic violations, you are seen as a higher risk and will pay more for coverage. If you have a criminal record, you will pay a higher premium or not be eligible for coverage at all.

Term life insurance can be a good idea if you are looking for a relatively inexpensive way to protect your loved ones that are dependent upon you for a set period of time. Many individuals who purchase term life insurance have young families that depend upon them and large financial obligations such as a mortgage.

If you are shopping for life insurance, it is also important to compare a term life insurance policy with a permanent life insurance policy. Both have their benefits, but understanding both types of policies can help you make a more informed decision.

1) Coverage duration - Term life insurance only covers you for a set period which typically ranges from 10 to 30 years. Permanent life insurance covers you for your entire life. This means the death benefit of a permanent life insurance policy is guaranteed to pay out regardless of when you die.

In this regard, term life insurance is usually purchased to protect you "if" you were to die unexpectedly during the term of the policy. Permanent life insurance is usually purchased to pay out a death benefit "when" you die

2) Cash value - Term life insurance is straightforward and only offers a death benefit. A permanent life insurance policy, such as whole life insurance, offers a cash value component in addition to a death benefit. This cash value is a tax deferred account that grows at a guaranteed rate by the insurer and never goes down in value.

You can make withdrawals from this cash value, take loans against it, and use it to pay for your cost of insurance (death benefit). Some individuals opt for a permanent policy as the cash value component will give them access to safe capital that they can use while they are still alive.

3) Cost - Since permanent life insurance has a guaranteed death benefit and a cash value component it is more expensive than term life insurance. For some individuals, this extra cost is justified as they plan to use a permanent life insurance policy throughout their life. For others, the affordability of term life insurance is more attractive.  

1) Know how much coverage you need

The exact amount of coverage that you need will vary. To estimate how much coverage you need; you can speak with an experienced life insurance professional or complete a LIFE needs analysis. Each letter of a LIFE needs analysis represents a different area of your life that you could want covered if you were to pass away. Once you have determined how much coverage you need for each letter, you add up the total.

a) Liabilities - You want to list out all of the items that you owe money on that you would want to be covered in the even that you die unexpectedly. This can include a mortgage, auto loans, car loans, credit cards, and others.

b) Income - You want to estimate how many years your family would be dependent upon your income if you were to pass away and add that to your coverage. For example, if you make $100,000 per year and estimate your family would be reliant upon that for 15 years, you would add $1.5 million in coverage.

c) Final expenses - If you pass away unexpectedly, your family will have to cover the final expense associated with that including your funeral and burial costs. You want to estimate what this would cost and add this to your coverage.  

d) Education - If you have children and plan on paying for their education, whether that be college or trade school, you want to estimate these costs and add them into your coverage.

2) Compare quotes

Once you have an idea of your desired coverage amount and policy type you can compare quotes from different life insurance companies. You can get quotes directly from a provider online or via the phone or use third party comparison sites.

Make sure to get quotes from life insurance companies with strong reputations and a history of strong financial performance. Also keep in mind that the prices you receive from quotes can change once you fill out an application.

3) Fill out an application

After you find a quote you like, simply fill out an application. These applications will gather information about your health, family health history, lifestyle, hobbies, occupation and more. Life insurance companies make sure to due their due diligence before issuing policies so expect to answer a lot of questions.

It is also important that you are honest about every question when filling out your application. Life insurance companies use third party sources to verify your application. They will be able to see medical records, prescription drug history, driving records and public records. There is a good chance you will be caught if you lie on your application.

4) Submit your premium to lock in coverage

Once your application is submitted, you can typically submit your first premium to bind coverage during the underwriting process. Underwriting is the process in which life insurance companies review your application before issuing the policy. If for whatever reason you are denied coverage, you will be refunded your premium.

5) Take a medical exam if necessary

During the underwriting process, you may be asked to complete a medical exam in addition to your application. This is standard practice for some companies. The life insurance company will typically send a medical professional to measure your height, weight, and conduct a blood and urine sample. The insurance company pays for this, and you will get a copy of your results.

The bottom line is term life insurance covers you for a set period which typically ranges from 10 to 30 years. If you die during the term, your death benefit will be paid out to your beneficiary(s). If you do not die during the term, your coverage will end.

Term life insurance is a good way to get affordable coverage when you have people that are dependent upon you. It is important to compare term life insurance with permanent life insurance to make sure you have the best solution to meet your needs.