How term life insurance works: The basics
A term life insurance policy is the simplest, purest form of life insurance: You pay a premium for a period of time – typically between 10 and 30 years – and if you die during that time a cash benefit is paid to your family (or anyone else you name as your beneficiary).
Term life is typically less expensive than a permanent whole life policy – but unlike permanent life insurance, term policies have no cash value, no payout after the term expires, and no value other than a death benefit. To keep things simple, most term policies are “level premium” – your monthly premium stays the same for the entire term of the policy.
Here are three key questions you should answer before you get a policy:
- How does a term life policy work?
- What are the different types of term policies?
- How much term life insurance coverage do you need?
How a term life insurance policy works
It’s a contract. At its most basic level, a term life policy is an agreement between the person who owns the policy (the owner) and an insurance company: The owner agree to pay a premium for a specific term (usually between 10 and 30 years); in return, the insurance company promises to pay a specific death benefit in cash to someone (a beneficiary) upon the death of someone else (the insured). That benefit is usually tax-free (unless the premiums are paid with pre-tax dollars).
There’s an application process. You may have seen or heard ads that say things like, “A male non-smoker in his 30s can get a 20-year $500,000 term policy for under $30 a month.” Some people can get that much coverage for under $30 – but it’s not automatic. Before they give you a policy, the provider needs to assess how much of a risk you are to insure. This is called the “underwriting” process. They’ll typically ask for a medical exam to evaluate your health, and want to know more about your occupation, lifestyle, and other things. Certain hobbies like scuba diving are deemed risky to your health, and that may raise rates. Likewise, dangerous occupational environments – for example, an oil rig – also may raise your rates.
You need to choose a term length. One of the biggest questions to ask yourself is, “How long do I need coverage for?” If you have children, a popular rule of thumb is to choose a term long enough to see them out of the house and through college. The longer your term, the more you’ll typically pay each month for a given coverage amount. Nevertheless, it usually pays to err on side of getting a longer-term policy than a shorter one because you just never know what the future holds and it is generally easier to get insurance while you are younger and in good health.
Decide how much of a death benefit you want. You should consider getting enough coverage to care for your family’s needs if you’re not there to support them; in section 3 we’ll tell you a few different ways to figure out how much that is. Whatever coverage amount you need, it will likely cost less than you thought: A recent survey found that 44 percent of millennials believe that life insurance is at least five times more expensive than the actual cost.1
Name your beneficiaries. Who gets the benefit when you die? It doesn’t all have to go to one person. For example, you could give 50% to your spouse and divide the rest between your adult children. And while beneficiaries are typically family, they don’t have to be. You could choose to leave some or all of your benefits to a trust, a charitable organization, or even a friend.
The different types of term policies you can buy
As you shop around and start talking to companies or insurance agents you may hear about different kinds of term policies. They all provide a specific benefit over a specific term but may have very different bells and whistles and costs.
- Level premium: Also called level term; this is the simplest, most common type of policy: Your premium stays the same for the entire term.
- Yearly renewable term: Also called an annual renewable term. This policy covers you for a year at a time, with an option to renew without a medical exam for the duration of the term – but at a higher cost each year. Compared to a level term policy, your premiums will be slightly lower at first, but over a full 10, 20, or 30-year term you will pay more than you would with a level premium policy.
- Return of premium: This type of term policy actually pays back all or a portion of your premiums if you live to the end of the term. What’s the catch? Your premiums could be 2-4 times higher than with a level term policy. Also, if your financial status changes and you let the policy lapse you may only get a portion of your premiums returned – or nothing at all.
- Guaranteed issue: These policies are easier to get because they don’t require a medical exam and only ask a few simple health questions at most. This also means that the insurance company has to assume that you are a risky prospect who has health issues, so your premiums may be much higher than they otherwise would be. Also, the policy might not pay a full death benefit for the first few years of coverage. If you have health issues but are able to manage them, it will usually be worth your while to get a conventional term life policy that is underwritten (i.e., requires a medical exam).
One more thing to look for in a term policy: Convertibility
Convertibility is a policy provision that lets you change your term insurance into a permanent whole life policy later on – without having to get a new medical exam. It’s a feature offered by almost all major insurance companies that let you change your type of life insurance. Guardian, for example, lets you convert level term insurance coverage at any point in the first five years to a permanent life policy – and even offers an optional Extended Conversion Rider which lets you do so for the duration of the policy. 2
Why would you convert to a whole life policy from term? If you’ve had a serious health problem – for example, a heart attack – it may be very difficult to get another policy. Another reason: you’re attracted to the cash value component of a whole life policy. Or maybe you want permanent life-long coverage. A term policy may well be your best choice now, but things can change.
Look for an insurer that offers the option to convert from term to a whole life policy without taking another medical exam, which would likely increase your cost. The chart below lists some of the important differences between a term life policy and whole life insurance, but if you want to find out more, talk to an insurance agent or financial representative.
|Policy feature||Term life insurance||Whole life insurance|
|Initial cost||Typically, lower than whole life||Generally, 6x – 10x more expensive than term for the same death benefit; but as cash value builds it can be used to supplement premiums.|
|Cost over time||Renewal cost increases with age||Cost stays the same for life|
|Length of coverage||Typically, 10 – 30 years||Lifetime coverage (as long as payments are made)|
|Premium||Can be level or increase over the length of the policy||Level – stays the same every month|
|Heath exam required||In most cases||In most cases|
|Cost can decrease over time||No||Yes – cost can be offset as cash value builds (typically after 12+ years)|
|Cash value||No||Yes – accumulates over time 3|
|Ability to withdraw cash value during life of the policy 4||No||Yes – withdrawals and loans are allowed (but if unrepaid, this will diminish the policy values and death benefit)|
|Guaranteed death benefit||Yes||Yes|
|Policy structure and provisions||Relatively simple||More complex|
How to determine the amount you need – and where to get it
If you have a young family, it will take many years of income to pay to feed, house, clothe, and educate your children through to adulthood. If you’re not there to provide for them, life insurance can help with those costs – but you have to make sure your policy’s death benefit is enough to do so. Here are a few general rules people use to help determine how much they need:
- Get 10x your salary: This is one of the simplest rules to follow, and it can provide a useful cushion for your family – but it doesn’t take all your actual expenses and needs into account.
- Get 10x your salary, plus college expenses: If you add $100,000 - $150,000 for each child, that can help ensure they can achieve more of the opportunities you want for them.
- Use the DIME formula: DIME stands for Debt, Income, Mortgage, and Education. Total your debts, mortgage and college expenses, plus your salary for the number of years your family needs protection (e.g., until the children are out of the house), and that’s your coverage need.
- Some financial representatives calculate the amount you need using the Human Life Value philosophy, which is your lifetime income potential – what you’re earning now, and what you expect to earn in the future. In its simplest form the philosophy suggests that you multiply your income by a variable based on factors such as age, occupation, projected working years, current benefits, etc.. As with every individual the amount of insurance you should purchase depends on many factors but a simple way to get that one number is to multiply your salary times 30 if you are between ages 18 and 40. The calculation changes based on your age group so refer to the chart below for your age group.
|Age||Maximum Life Insurance|
|18-40||30 times income|
|41-50||20 times income|
|51-60||15 times income|
|61-65||10 times income|
|66-70||1 times net worth|
|71-75||1/2 times net worth|
Any of those methods is a good start, but it also makes sense to talk with an experienced professional who can guide you through the process of calculating your actual need.
Where to get term life insurance
If your company offers group life insurance as part of your employee benefits package, that can be a great place to start. Because the company is buying for a large group of people, the premiums are typically lower than for an individual policy. Your employer may also subsidize a portion of the premiums or even provide coverage equal to your annual salary at little or no cost. On the other hand, the total amount of coverage you can get may be limited, for example to three times your salary. And if you leave the company you could lose your coverage.
Even if you have some coverage thorough work, it may not be enough for your needs. The good news is, term life insurance is generally easy to shop for: Many companies, including Guardian, will give you an instant online quote.
Compare insurance rates from a couple of sources, and before you make a choice consider the company you’re buying from. You’re looking to have a long-term relationship with that company, so look for the following qualities.
- Financial strength 6: First and foremost, you want to be confident that the company will be around when your family needs a payout years or decades down the road. The best way to do that is to look for companies with strong Financial strength ratings. That includes a rating of at least “Superior” (A+) from A.M. Best (the insurance industry’s number one rating agency), a “Very Strong” (AA-) from Standard & Poor’s, or an “Excellent” (Aa1) from Moody’s.
- A company that underwrites its own policies: Some companies act as middlemen who sell policies from another insurer, and this can add costs to your premiums. It can also add an extra layer if you want to change your policy – or down the road when your family needs a payout.
- Guaranteed term renewability: If you become critically ill near the end of your policy’s term, you’ll want to be able to renew without taking another medical exam. Some companies offer this on a year-to-year basis – and while you can expect your rates to rise substantially, it may be worth it for your survivors.
Another way to compare insurance companies is by looking at online customer reviews. While these aren’t likely to tell you much about a company’s financial stability, it can tell you how easy they are to work with, and whether claims servicing is a problem.
Want to talk things over with someone before you buy term insurance? That’s a great idea. Guardian can connect you with a financial representative who will listen to your needs, tell you about the best ways to meet those needs within your budget and types of life insurance policies available, then will help you decide. Whichever way you decide to buy, consider doing it soon. Remember: the longer you wait to get life insurance, the more you’re likely to pay.
Frequently asked questions about term life insurance
What happens if I outlive my term life insurance policy?
Generally speaking, when your term life policy ends, you either have to buy another policy at a higher cost or go without life insurance. However, if your policy has a guaranteed renewal clause, you can renew at the end of your term on a year-by-year basis, but at a higher rate. While expensive, it can be worthwhile if you have been diagnosed with a terminal disease that makes you otherwise uninsurable.
Do you get your money back at the end of a term life insurance policy?
No – unless you have a return of premium policy. However, such policies can be 2-4 times more expensive than a regular level term life insurance policy.
Can you cash in a term life insurance policy?
No – a term life policy has no cash value component. If you want a policy that provides a death benefit and builds cash value over time, you should consider getting a whole life insurance policy.