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Term Life Insurance – What It Is and How It Works

It’s human nature to wish for a long, healthy, happy life for yourself and your loved ones.

Sadly, that’s not in the cards for everyone. That’s why life insurance — specifically, term life insurance, the most affordable type of coverage — factors into so many families’ long-term financial planning.

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Contrary to one of the most persistent myths about life insurance, most people should at least consider term life insurance coverage during the early and middle years of their adult lives. But it’s not appropriate for everyone. To determine whether term life insurance is right for you, learn more about how it works, who needs it, and when it’s just not worth the cost.

Pro tip: Life insurance can be confusing for many people. That causes the process of purchasing a policy to be stressful. But Ladder makes purchasing life insurance simple. With a few simple questions, you can apply for a new policy in just minutes.

Term Life Insurance in a Nutshell – Term vs. Permanent Life Insurance

Term life insurance is one of two categories of life insurance. The other is permanent life insurance, whose sub-types include whole life insurance, universal life insurance, and variable universal life insurance. Each type of permanent life insurance differs from term life insurance in several key respects:

  • Policy Term. Whereas term life insurance policies have fixed, temporary terms, permanent life insurance policies remain in force indefinitely, most often until the policyholder dies or cashes out the policy.
  • Cash Value. Permanent life insurance policies build cash value over time. Though cash value builds slowly and remains essentially worthless for the first few years of the policy, its value can approach that of the death benefit toward the end of the policyholder’s life. By contrast, a term life insurance policy has no cash value and expires worthless when the policyholder outlives the term.
  • Policy Premium. Permanent life premiums tend to be much higher than term premiums, on the order of five to 10 times. For some policyholders, the guarantee of lifetime coverage and the option of tapping the policy’s cash value justify the higher cost, but it’s important to understand upfront.

Let’s look at each key feature of term life insurance in greater detail.

The Policy Term

The distinguishing feature of term life insurance is its temporary term. Whereas a permanent life insurance policy remains in force until the policyholder dies, cancels and cashes out the policy, or lapses on payments, term life insurance expires at a predetermined future date. Though policyholders often have the option to extend coverage for an additional term or convert to a permanent policy, they aren’t obligated to.

Initial policy terms typically run from 10 to 30 years, with 10, 15, 20, and 30 years being the most common term lengths. Longer or shorter initial terms are rare but do exist. If offered, an option to renew (rather than convert to permanent) usually presents as a series of one-year extension terms with significantly higher premiums than the initial term.

The Policy Premium

Like all types of insurance, term life insurance policies require policyholders to pay premiums on time and in full (subject to a grace period) to maintain coverage. Term life insurance premiums generally remain fixed during the term and increase with the policyholder’s age at the time of application — which is why it’s essential to apply for term life coverage earlier in life.

Insurers also use other variables to set term life premiums. The most notable include:

  • Coverage amount (death benefit)
  • Term length
  • The policyholder’s family medical history
  • The policyholder’s health and health history as determined by the results of a medical exam, self-reported answers to health-related questions, and any available health records
  • The policyholder’s lifestyle and habits, including tobacco use and any risky jobs or hobbies

Policy premiums increase proportionally with the size of the death benefit and the length of the initial policy term. Risky behaviors and health concerns also increase premiums. Insurers reserve the right to deny coverage altogether to applicants with serious health issues that could significantly shorten life expectancy.

The Death Benefit

Every term life insurance policy has a death benefit. It’s the amount paid to the policy’s beneficiary or beneficiaries if the policyholder dies while the policy remains in force. With rare exceptions, such as application fraud or death by suicide during the first two years of the policy, insurers make good on their promise to pay death benefits in full.

Like permanent life insurance death benefits, term life insurance death benefits are not subject to federal or state income tax. However, unlike permanent life insurance policies, term life insurance policies don’t accrue cash value. Absent a terminal diagnosis, there’s no way for the policyholder or beneficiary to tap the death benefit before the policyholder’s death.

If the policyholder outlives the policy term and chooses not to renew, the policy becomes worthless and the death benefit evaporates. If the policy offers a return of premium rider or the death benefit isn’t paid at the policyholder’s death, the policyholder or beneficiary could recoup some or all premiums paid over the lifetime of the policy. Otherwise, the insurer keeps any premiums paid.

Who Needs Term Life Insurance?

The simple answer to this question is that most people need some kind of life insurance.

More specifically, anyone who believes their premature death would cause a financial burden for their loved ones needs it. That’s more likely to be the case for would-be policyholders who:

  • Have Children or Plan to Have Children. Food, clothing, day care, school supplies, extracurricular activities, postsecondary tuition (and perhaps elementary and secondary tuition as well) — the list goes on and on. That leads to one inescapable conclusion: Children are really expensive. Adequate life insurance ensures your kids’ surviving parent or guardian(s) don’t have to raid their savings or go into debt to do right by your kids after you’re gone.
  • Carry Substantial Joint or Nonforgivable Debts. It wouldn’t be fair of you to leave your spouse holding the bag on a joint mortgage or saddle them with debts that can’t be forgiven in death, such as private student loans (an especially important consideration for residents of community property states). If you carry or plan to carry substantial debts with your spouse and lack — for the foreseeable future — sufficient liquid assets to settle them in probate, term life insurance is most likely worth the cost.
  • Earn Significant Income for the Household. Even if you’re not the primary or sole breadwinner, your family will miss your income after your death. The very rough rule of thumb for the amount of life insurance you need is 10 times your annual income when you apply. In other words, a death benefit significant enough to replace 10 years of income at your current pay rate.
  • Want to Provide a Financial Cushion for Survivors. Life insurance can dull the shock of financial unknowns, such as end-of-life medical care not covered by insurance or child care expenses incurred by a surviving spouse returning to work.

Hands Holding Silhouette Of Family White Cut Out Insurance Policy Concept Covered

When Term Life Insurance Might Not Be Worth the Cost

Most adults should at least consider term life insurance, especially if they’re young and healthy enough to obtain ample coverage at relatively low cost. But it bears repeating that there are times when term life insurance isn’t worth the cost.

You Don’t Have Dependents & Don’t Plan To

No doubt about it, kids are expensive. If you’re as confident as can be that you won’t ever have or adopt children, the massive long-term cost of raising them — before or after your death — need not concern you.

The caveat to this general principle is that you probably will need life insurance if you do end up with kids later in life. That’s most likely to happen due to an unexpected pregnancy or a decision to adopt. But rarer circumstances can arise as well, such as inheriting guardianship of a sibling or friend’s children after tragedy strikes.

But note that the cost of term life insurance increases with each year of age, and years can pass between deciding to expand your family and actually welcoming kids. So get life insurance as soon as you know your circumstances have changed.

You Don’t Have Significant Debts & Don’t Plan To

Whether you’re a renter by choice or circumstance, your determination to avoid joint ownership of a home could significantly reduce your need for life insurance. The same is true for other major debts, such as education loans, unsecured personal loans, and loans you’ve cosigned for a spouse or relative.

It becomes a trickier consideration for would-be policyholders in community property states, where both spouses are generally liable for debts incurred during a marriage. If you live in a community property state and rack up tens of thousands of dollars in credit card debt throughout your marriage, that burden could transfer to your spouse after your death. That increases your chances of needing life insurance, even if you’re otherwise debt-free.

You or Your Spouse Have Ample Liquid Assets or Equity in Nonliquid Assets

If your debt burden is relatively low, your net worth relatively high, and you see no significant expenses (such as college tuition for school-age kids) on the horizon, your survivors won’t need to rely on your policy’s death benefit. That’s more likely for would-be policyholders with spouses working full-time and no kids or dependents. In such a case, the policyholder’s death wouldn’t meaningfully affect the surviving spouse’s lifestyle or financial position.

You’re on the Older Side

The cost of life insurance invariably increases with age, shrinking the death benefit-to-premium ratio over time. Due to the complexity of calculating life insurance premiums, there’s no general age threshold at which term life insurance is no longer worth the cost. The answer varies according to the applicant’s health and desired policy term, among other variables.

However, to keep premiums manageable, applicants over age 50 should consider shorter terms — perhaps 10 to 15 years. Over age 65, premiums can be prohibitively expensive, even for applicants in good health. Seniors whose savings aren’t adequate to cover their funeral and burial costs should consider final expenses insurance, a low-benefit term policy designed specifically for that eventuality.

You’re a Child or Dependent With Little or No Income

Sorry, kids. Your turn to buy life insurance will come eventually. For now, you’re simply not productive enough to bother insuring.

(Seriously, parents: Don’t fall for those heartstring-tugging children’s life insurance ads. Immensely and senselessly tragic though it may be, the death of a child is not a financial imposition.)

Final Word

Were life insurance only sold as a hedge against the relatively low likelihood of one’s premature death, life insurers would have a much tougher time selling it.

Of course, that’s not the case. You needn’t spend all day watching life insurance commercials to realize that life insurance’s biggest selling point isn’t financial protection. It’s peace of mind.

When you buy term life insurance, you’re not just buying a financial windfall that may never come. You’re buying the assurance that if anything happens to you, your family won’t suffer serious financial harm.

In other words, you’re buying better sleep for as long as your policy term lasts. If that sounds like a sound investment, then term life insurance is probably worth it for you.

Are you thinking about applying for term life insurance? What’s holding you back?

Brian Martucci
Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.

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