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Term life insurance is a policy that offers coverage for a specified period of time. So, should the insured pass away while the policy is in effect, the beneficiary (often the spouse or child of the insured) would receive a payout.
- How Does Term Life Insurance Work?
- Types of Term Life Insurance Policy
- Additional Scenarios to Understand
- Should I Buy Term Life Insurance?
How Does Term Life Insurance Work?
Term life insurance policies can be purchased to cover nearly any period of time, and will stay in effect for the entire period as long as you continue to pay the premiums (the cost of the policy, which can be paid on a monthly or annual basis). While term life insurance doesn’t accrue a cash value over time, meaning you can’t borrow against it, a term policy has a low cost by comparison and is still customizable to an individual’s situation.
Term life pays out the value of the policy upon death in almost all circumstances. This payout is called the death benefit or face value of the policy, can vary from $10,000 to above one million dollars. The amount of coverage you need depends on your particular financial situation, but you generally want to make sure your family will be able to cover any outstanding financial obligations, such as your:
- Children’s education (including college tuition)
- Funeral costs
- Auto loans
- Student loans
- Living expenses (for a number of years)
If you pass away within the number of years the term policy is active, than the beneficiary would submit a claim. The life company may take some time to investigate the circumstances of the death but, if all passes muster, then the insurer will pay out the death benefit or protection amount in a lump sum or in annual payments. Make sure to let the beneficiary know about the life insurance policy, as if they don’t know to file a claim they may not receive the death benefit.
One exception to that rule is suicide. Insurance companies all handle this differently so we recommend that all parties read through the terms. In general, suicide within 2 years of purchasing the life insurance policy is excluded from being paid out.
Types of Term Life Insurance Policy
Term life insurance policies vary according to several factors, meaning the policy that is best for one person may be non-optimal for you. It’s important to understand how each of these policy features work in order to find the product that is best for your family and financial plan.
Length of Term
When choosing a term policy, you have to pick how long you want the coverage period, or term, to be. If the insured person departs within that time frame, the listed beneficiaries will receive funds from the life insurance company. While some policies are as short as one year, term policies are generally available in periods of:
- 5 years
- 10 years
- 20 years
- 30 years
As an alternative, many insurers also offer the option of term coverage until you reach a certain age, such as 65. This is essentially the same product, as it offers coverage for a pre-determined number of years so long as you consistently pay the premiums, however builds in flexibility regarding the exact time length. For example, if you intend to retire at 70 and have determined that you’ll need $750,000 to cover your family’s costs post-retirement, but you’re 60 and have only saved $600,000, you may choose a term life insurance policy that offers $150,000 of coverage should anything happen to you before then.
Level or Decreasing Term Life Insurance
The key question to ask when choosing between a level and decreasing term life insurance policy is whether your dependents would need less coverage should you pass closer to the end of the term than they would should you pass in the next few years. Level term life insurance, by definition, offers the beneficiaries the same payout over the entire length of the term.
Decreasing term life insurance may be more appropriate if you’re in the process of paying back loans and want coverage to make sure these wouldn’t be transferred to your dependents. You pay a flat premium over the duration of the policy, but the face value (death benefit) of the policy decreases over time. The idea is that a person may need a higher death benefit earlier in life (as they're paying off their home, raising children, etc.) than they do as they get older.
Say your spouse’s income is high enough to cover normal living expenses, but not the 20-year $500,000 mortgage on your house. You might choose a decreasing term policy for a similar term length and initial death benefit equal to the outstanding mortgage loan, since you know your spouse will be financially stable once the mortgage is paid off and you know the time it will take to pay back the loan.
Renewable Term Life Insurance
Short term life insurance policies often have the option of being renewable, meaning each year (or 5 years, depending on the term) you essentially purchase a new policy with the same insurer, under the same terms. The benefits of this type of policy are that you can get coverage for a short period and have the option to renew without going through a lengthy underwriting process. But the downside is that your premiums will increase each time you renew, as you’re older and in a higher risk bracket.
These policies can be helpful if you have a significant financial obligation for a short period of time but are unsure of the exact number of years. New small business owners, for example, may take on significant debt to launch their venture and have an approximate timeline for paying that debt off. However, if the actual time to profitability is 7 years instead of 5 years, as planned, the business owner may want to renew their life insurance policy to make sure any debts would be covered.
Simplified Issue and No Medical Exam Life Insurance
Simplified issue term life insurance, also referred to as “no medical exam” life insurance, may sound great, but is a significantly more expensive product that may not be worth the convenience. While the underwriting process for life insurance can take several weeks, the actual medical exam is quite short (often less than 30 minutes) and can often be scheduled to take place at your home or work. This means a no medical exam policy may cost you thousands of dollars in additional premiums over the term of the policy, while saving you less than an hour.
The only time no medical exam life insurance may be a good financial decision is if you question your ability to pass a medical exam. However, as part of the application process, you’ll still be required to complete health and lifestyle questions in the insurance application and, in the case the insurer finds you’ve misstated anything, your policy may be canceled.
Convertible Term Life Insurance
Many insurers offer convertible term life insurance policies, meaning that for a specified period of time you can convert the term policy to a permanent life insurance policy without going through a new medical review. We recommend having a convertible term policy as your financial situation will change over time and, for example, if your income rises and you later decide that you want a permanent life insurance policy to take advantage of the tax benefits, that option will be available.
As having a convertible policy doesn’t change the insurer’s risk while you maintain the term policy, it shouldn’t increase your premiums and is generally just beneficial as it offers convenience should your financial situation change. Just make sure to note the period of time during which you’re allowed to convert the policy.
Additional Scenarios to Understand
Riders are essentially customizations to an insurance policy, and the selection available for a particular policy varies according to the insurer and insurance product chosen. While some riders sound appealing, they need to be evaluated carefully as the financial benefits may not exceed the actual cost.
For example, you may have heard of a “return of premium” rider which pays back a percentage of your premiums should you outlive the term of your policy. This may sound perfect to a parent that’s getting a term policy to cover their children’s education in the case anything happens before the child completes college. However, the rider would increase the premiums of the policy and, even though you would get that money back, that value would be locked up in the policy. So, if you died during the policy term or had a sudden expense come up, it would not be available.
Voluntary and Group Term Life Insurance
Group life insurance is offered through an employer as a benefit and is often term life insurance, as opposed to permanent life insurance. The employer might offer a certain amount of coverage at no cost with the option for employees to take advantage of a discounted group rate in order to get additional coverage. Voluntary term life insurance just refers to the additional coverage that employees can opt-in to purchase, hence the “voluntary” title.
While group term life insurance comes at a discount, the policies tend to be less customizable and often are not transferrable, meaning that if you change employers the coverage ceases. Given the median tenure for employees at a particular job is less than 5 years, it’s likely you’ll move to a new company within the term of coverage, and you’ll have to get a new policy which is likely to have higher premiums since your age has increased. It’s important to evaluate the options available and terms of the policy before purchasing group coverage.
Direct Term Life Insurance
“Direct term life insurance” simply refers to a term life insurance policy in which the party upon whose death the benefit would be paid out is the same party paying for the policy. If a life insurance policy was taken out for you by a third-party, such as an employer or family member, then it would not be a direct term life insurance policy.
Should I Buy Term Life Insurance?
Whether you need term life insurance is typically dependent upon whether you have dependents, such as children or a partner, that would be in a financially challenging situation should you pass. If you don’t have dependents or outstanding debt that would be passed on to others, a term life insurance policy is likely not appropriate.