Purchasing life insurance is a wise and prudent decision. It will provide your family members or loved ones with the support they need to keep going after your death, and prevent your absence from becoming a heavy financial burden.
Life insurance is a standard product offered by insurance companies. It only involves a few concepts: the insured, premiums, policy term, beneficiaries, and payouts. Additionally, in many cases it also includes a savings component that accumulates part of the capital you pay in premiums, money that companies invest to earn extra benefits.
There are various types of life insurance currently on the market based on different combinations of these key elements. Generally speaking, there are two main types of life insurance: permanent life insurance and term life insurance. In this article, you will learn about term or temporary insurance, which is a great option if you need coverage for a set period of time at a good price.
Term Life Insurance: Article Contents
What Is Term Life Insurance?
Unlike permanent life insurance, which is valid for the rest of your life, term or temporary life insurance allows you to purchase a policy that will only be valid for a set period of time.
Here you can find more information on term life insurance versus permanent life insurance.
This means that the product has a term, or expiration date. If the insured dies during this period and is up-to-date on the monthly premiums, the beneficiaries will receive a payout.
If the insured is still alive come the expiration date, the payout will not be issued. The insurance policy will simply expire and the relationship between the insured and the company will dissolve, unless it is renewed by mutual agreement.
Despite the specific functions of term life insurance, these products are rather simple and consist of two basic concepts: the term or validity of the policy and the amount of money collected by beneficiaries as a payout or death benefit.
As such, they are relatively easy to manage and understand, and offer many financial advantages, as they are cheaper than permanent policies. This is because the premiums are calculated to cover your short-term risks, which are lower than those of long-term insurance.
This makes term life insurance a great option if you want to pay lower premiums in exchange for a good payout, and especially if you need to cover a concrete period of time. What’s more, the fees for canceling or terminating the insurance are lower. In exchange, however, you will not be able to earn cash value. With permanent insurance, cash value is the money that is earned with the excess you pay in premiums to cover your long-term risks. This money is invested to reduce your future payments, but it will eventually exceed the amount needed to cover these costs. Then, it must legally be made available to you, and can even be borrowed against. Term insurance, on the other hand, does not earn a cash value.
How Does Term Life Insurance Work?
If you’re thinking of purchasing a policy, you should know how term life insurance works before you start requesting quotes. It’s not very complicated, but as with any similar product, you do need to pay attention to the details.
As we’ve seen, this type of insurance is designed to last for a limited time. It can be a set period of years or, for example, until you reach a certain age.
It’s designed this way to provide you with the assurance that your family or affairs won’t be left high and dry if you die during that time: the payout will help them overcome this time without you. For example, this insurance can cover the period of your children’s college education. With that money, your kids won't be left without money for tuition if you die while they are students.
Keeping this in mind, term life insurance is simple and consists of a few specific elements you should be aware of:
- Term. The term is what determines the basic feature of the insurance. As the insured, you choose how many years you want your coverage to last. The minimum is one year, which can be renewed. After that, there are policies with 5-, 10-, 15-, 20-, or 30-year terms. Lastly, there are policies that last until you reach a certain age: 65, for example.
- Qualification. The qualification process is less demanding, because the medical exams or reports it requires are generally less exhaustive. They will ask you for information such as your sex, age, height, weight, lifestyle, finances, and whether you smoke. In some cases, they will also request some simple medical exams, such as blood pressure or blood or urine tests.
- Premiums. These are the amounts you pay each month. Again, they tend to be lower than permanent insurance premiums. This is because the insurer takes on less risk, which greatly affects the price. These premiums also tend to be less flexible and, in most cases, are level: the amount always stays the same. However, there are cases in which premiums vary over the term of the insurance.
- Beneficiaries. As with the majority of life insurance policies, as the insured, you decide who will collect the payout if you die while the insurance is valid. Choosing your life insurance beneficiaries is very important. You can name primary beneficiaries, as well as secondary and even tertiary beneficiaries. These will be the people or organizations who will be entitled to the death benefit. You can set the order in which they can access this payout. You can also name a trust as a beneficiary, which will administer the money according to your wishes.
- Coverage or payout. This amount is fixed and cannot be changed. If, during the term of the insurance, you discover this amount is insufficient to cover any anticipated costs when you die, you will not be able to increase it. Instead, you will have to purchase an additional term life insurance policy to meet this need. In any case, the payout, also called the death benefit, is the money the beneficiaries will receive, and it is tax-free.
- Renewal. This is an important factor you need to take into account if you want a new policy when the one you have ends. If your policy expires and is not renewable, you will need to go through the qualification process again to access a new term life policy. Since you purchased your first policy, your health may have worsened and you will be older, which means the company will take on more risk and may deny the new insurance or set higher premiums. For this reason, you should consider renewable term life insurance. With this variant, you will avoid any health-related qualification issues: you will not have to take any new exams or answer more questions about your health or finances. However, bear in mind that you will have gotten older, which means the premiums will adapt to your age and may be higher.
- Conversion. Another way to avoid the problem of re-qualifying is converting term life insurance to permanent insurance before your term policy ends. Permanent insurance has no expiration date: it will remain valid until the death of the insured. What’s more, the conversion can be made either when the insurance expires or, more commonly, at any point in the insurance’s life.
During the conversion, your premiums will likely increase to adapt to your age, but you won’t have to go through the medical exams and the long and arduous initial qualification process. This option is generally only offered if the insured is under 65.
In addition to avoiding the complex qualification process, converting to permanent insurance offers many advantages. Firstly, the payout is now guaranteed. Secondly, the policy now includes a savings component that will earn extra money that can be used to reduce your future premiums or take out loans. The cash value in these policies generates profits, the taxes on which can be deferred until you withdraw the funds, resulting in significant tax benefits.
Additionally, if you receive dividends or surrender the policy, these are exempt from taxes until the amount received is greater than the total paid in premiums.
Lastly, you can also opt for partial conversions: part of the term policy will become permanent and the rest will remain as it was. This option is more affordable.
Types of Term Life Insurance
Now that you know how it works, it’s time to choose what type of term life insurance you should purchase. The primary differences between term insurance policies lie in premium format and death benefits, but also in use cases and the circumstances of the insured. Here are the main types of term insurance:
- Level-premium term life insurance This is the most common form, selected by the majority of term insurance clients. Throughout the entire term of level-premium policies, the amount of your monthly premiums will remain the same. These premiums are always lower than those of permanent insurance.
- Decreasing term life insurance As the expiration date of a decreasing term life policy grows closer, the payout will decrease, as will your monthly premiums. It is designed this way so that, for example, if you’ve taken out term insurance to cover your child’s college education, you will pay much less for insurance in the last year because they’re almost done with college, and if you die, it will no longer be so difficult for your child to finish their studies. As your risk decreases, so do your payments, also resulting in a decreased payout.
There are also alternatives to these two main types of term insurance, which can be useful in certain circumstances. They are as follows:
- Increasing term life insurance This is the opposite of the last type: the payout grows as the years go by. Your premiums will rise, as will the death benefit. This variant is interesting for people who have difficulties paying for insurance. If you start off paying less, it may be easier to handle the payment during the first few years. Later on, as your financial situation improves, the prices and death benefit will increase.
- Annual renewable term life insurance In this case, the policy expires and is renewed every year. You have more freedom to change insurance, but your monthly premiums will rise with each renewal. This is because each year you grow a little older, so the insurer will recalculate its risk, which increases with age, and hike up the prices.
- Guaranteed or simplified issue term life insurance Guaranteed or simplified issue policies are used in cases where the insured has a disease or health condition that significantly increases their risk of death. Insurance companies typically don’t request medical reports for this type of term insurance and only require information from the insured, which is why the insurance is guaranteed to be issued. Logically, the risk the company takes on is very high, and so are the premiums. Some of these policies have what's called a graded benefit: they provide lower payouts in the first few years of coverage.
- Final expense term life insurance This type is designed for people who only want to purchase insurance to cover their funeral expenses. Insurance companies cannot reject you, but the death benefits they offer are lower and the premiums typically higher.
More information on final expense insurance.
- Return of premium term life insurance This variant of term life insurance returns your premiums if you are alive when the insurance expires. Premiums for this type come with a hefty surcharge to guarantee their return at the end of coverage.
- Mortgage life insurance. While not strictly term life insurance, mortgage life insurance does share some of its features. People who take out a mortgage are generally required to purchase this insurance by banks. These policies have the same duration as the mortgage, hence the relationship with term insurance. If the mortgagor dies before repaying their loan, the company will return the money to the bank.
More information on mortgage life insurance.
Term Insurance Coverage: Why Do You Need It?
If you’re thinking about selecting term life insurance, make sure you’re clear on why you need it: there are many reasons to purchase life insurance. Take into account your personal situation, your family’s situation, and your environment. Compare your options and make an informed decision.
Most people who opt for term life insurance do so to cover one of these potential risks:
- Covering your children’s education. Life insurance for the time they have left in school will ensure that they will be able to cover tuition or other school expenses if you die.
- Covering childhood. Childhood is a tricky time, and all parents are worried of anything happening to their young children. Term insurance will cover their needs if this occurs.
- Covering a mortgage or loan. If you’re worried that your death will leave your spouse in a bind for repaying a mortgage or loan, you can cover yourself with this type of insurance. However, in this situation, you may be able to purchase mortgage insurance to cover this risk. If you combine it with another type of term insurance, your coverage will be much more comprehensive.
- Paying off debts. If you have debts and don’t want anyone to be responsible for them upon your death, you can purchase insurance to prevent this. Your situation may be temporary, so term insurance will cover you while you finish paying off your debts.
- Maintaining standard of living. If you’re worried that your death will leave your family unprotected due to lack of income, term insurance can function as an income replacement.
- Funeral. If you don’t want your funeral and related expenses to be a financial burden on anyone, final expense term insurance will solve this problem. As we’ve seen, there are specific types of insurance for final expenses. Again, a good solution would be to combine two types, a final expense policy with a term one.
Of course, term insurance can cover many things. But you shouldn’t rule out the option of combining insurance. For example, term insurance might be the best option for you in the short term. But you should also think long-term and consider purchasing a permanent insurance policy at an affordable price. When your term insurance ends, you will always have your permanent coverage. You can also convert your term policy into a permanent one, but remember that the later you do it, the older you will be--and so your premiums will be higher. You can avoid this problem by purchasing permanent insurance earlier.
In summary, term life insurance can be a very advantageous tool that will protect you from any unexpected events during the time you need it.
When requesting a life insurance quote, compare permanent life insurance to term life insurance. You’ll find great prices and will be spared from most of the complicated qualification process.
This article was updated on July 9, 2018.