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Term life insurance is a type of life insurance contract that only pays a death benefit if the insured person dies within a specific period. If the person doesn’t pass away during the term, the policy expires and doesn’t pay a benefit.
Purchasing a term life policy is a surprisingly affordable way to provide financial protection for your loved ones. Read on to learn how term life insurance works, the pros and cons, and what to consider before buying a policy.
What is term life insurance and how does it work?
A term life insurance policy is pretty simple to understand. When you apply for a policy, you’ll determine how much coverage you need, as well as the policy’s term, i.e., the length. Typical terms are 10, 20, and 30 years. You’ll pay premiums to the life insurance company during the term to keep the policy in force, usually monthly or annually.
If you die during the term, your insurance company will pay out the policy’s death benefit to your beneficiaries. The death benefit is paid in a lump sum that’s tax-free for your loved ones. But if you’re still alive at the end of the term, the policy expires without paying a benefit.
Most policies nowadays are level-term policies, meaning they pay the same death benefit no matter when the death occurs during the term of coverage. With a decreasing term policy, the death benefit gets smaller as the policyholder ages.
Term life insurance is sometimes referred to as pure life insurance because its sole purpose is to provide a payout to your beneficiaries if you die during the term. There’s no cash value, which is a savings account-like feature of permanent life insurance policies.
Term vs. whole life insurance
There are two basic types of life insurance: term life insurance and permanent life insurance. Whole life insurance is the most common type of permanent life insurance.
There are two major differences between term and whole life insurance:
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Term life insurance only pays a death benefit if you die during the specified term, whereas whole life insurance offers a guaranteed death benefit for your entire life.
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Whole life insurance has a savings component called cash value that you can take loans or withdrawals from while you’re alive, but term life insurance has no cash value. Term life offers only life insurance coverage, while whole life insurance is a hybrid product with insurance and savings/investment features.
Because of the lifetime coverage and cash value component, whole life premiums are far more expensive than term life premiums. Whole life premiums can be anywhere from five to 15 times higher than 20- or 30-year term life premiums with the same amount of coverage.
Benefits of term life insurance
Term life insurance coverage offers many benefits, the most important being financial protection for your loved ones. Some advantages include:
Affordability
Term life insurance premiums are far more affordable than other types of life insurance policies with similar death benefits. Dollar-for-dollar, your term life premiums will buy you a much larger death benefit than you’d find with permanent life insurance.
The amount you’ll pay will vary based on your age, gender, health conditions, occupation and whether you’re a smoker. The younger and healthier you are, the lower your premium payments will be. But even if you have pre-existing health issues, you can often obtain term coverage at an affordable rate.
Flexibility
With term insurance, you can buy a policy based on your specific circumstances. Many people choose a death benefit and policy term according to their financial obligations. For example, you may want to buy enough coverage to pay off your mortgage, replace your income until your children reach adulthood, or cover the costs of your kids’ education. Some people also buy coverage to protect their parents if they co-signed on student loans.
Ability to cancel any time
You can cancel term life insurance at any time without incurring fees if you decide you no longer need coverage.
Disadvantages of term life insurance
Of course, term life insurance won’t be the right choice for everyone. Here are some drawbacks to consider before you purchase a policy.
No cash value
Unlike permanent life insurance, term life insurance doesn’t build cash value. If you want a policy with a built-in savings or investment component, consider a whole life, universal life or variable life policy.
Expires at the end of the term
Term life insurance won’t pay a death benefit if you outlive the term. Your premiums won’t be refunded unless you purchase an add-on called a return of premium rider, which can make your policy as much as five times more expensive.
Having coverage that expires isn’t always problematic, though. If you live into your 80s or 90s, it’s less likely that you’ll have people who financially depend on you. However, if you want your survivors to receive a payout no matter when you die, you’ll need permanent coverage.
Increased premiums when you renew
If you still need protection after your term expires, you’ll need to renew your policy or purchase a new one. Most term policies offer something called guaranteed renewability, which means you can extend the policy and its death benefit without going through the underwriting process again or having another medical exam.
But your premiums will usually be higher. That’s because our lives become more expensive to insure as we age. For the same reason, purchasing new term insurance when your policy expires will typically be more expensive.
Term life insurance rates and costs
When you apply for term life insurance, carriers will assess how risky of an applicant you are. The higher your risk of dying during the specified term, the more you’ll pay. Some important factors that affect term life insurance rates include:
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Age: Because the risk of death grows higher as you get older, your date of birth is the most important factor insurers consider.
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Gender: Premiums are typically lower for women than for men because women have longer life expectancies.
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Health history: Insurers usually review your health records and often require a medical exam during the underwriting process. Some medical conditions will result in higher term life insurance costs or a denial of your application. Carriers will also ask about your family’s history of illness.
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Tobacco usage: Because smoking carries a higher mortality risk, smokers pay higher premiums. You can often qualify for non-smoker rates after being tobacco-free for one or two years.
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Hobbies and occupation: People in high-risk occupations, like first responders and construction workers, can expect to pay a higher premium. The same goes for those who engage in risky hobbies, like skydiving or rock climbing.
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Policy terms: Longer policy terms mean there’s a higher chance a life insurance company will have to pay a death benefit, so you’ll pay more for a 20-year or 30-year term policy than you would for a 10-year term. The higher your death benefit, the higher your premiums will be, as well.
Coverage amount and term length
Your coverage amount and term length will depend on your needs and what you can afford, as well as what you’re approved for during the underwriting process. Someone who is 70 is unlikely to qualify for a 30-year term and would probably have to settle for a 10- or 15-year policy.
The DIME formula (debt, income, mortgage, and education) is a common method for determining how much term life insurance you need. Using this formula, you’d add up the following:
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Debt: Total non-mortgage debt
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Income: Your salary times the number of years your family would need to replace that income. Many people use the number of years until their youngest child graduates from high school. So if you earn $60,000 a year and your youngest is 8 years old, they’d be 10 years about graduating, so you’d need about $600,000.
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Mortgage: Total amount you’d need to pay off your mortgage and any home equity loans
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Education: The amount you anticipate paying for each child’s education
Because your individual needs may be unique, consider working with a life insurance agent to determine the right terms and coverage and get multiple life insurance quotes.
Learn more: Do you need mortgage protection insurance?
Additional options and riders
When you buy term life insurance, you’ll often have the option to purchase add-ons known as life insurance riders for an extra cost. Some common life insurance riders include:
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Accelerated death benefit rider: Allows you to access your death benefit if you’re diagnosed with a qualifying illness (usually, one that’s terminal).
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Accidental death benefit rider: Increases the policy’s death benefit if you die in an accident.
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Child or spousal rider: Provides a small death benefit if your child or spouse dies during your policy term, typically to cover final expenses.
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Term conversion rider: Gives you the option to convert a term policy into a whole life policy at the end of the term.
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Waiver of premium rider: Allows you to stop paying premiums while keeping the policy in force if you become disabled.
Does a term policy meet your life insurance needs?
If you have dependents who would struggle financially if you died, life insurance is a must. One of the biggest benefits of term life insurance is that it provides valuable protection for your loved ones at a low cost.
Because coverage only lasts for the policy’s term, it’s appropriate when you have specific obligations or temporary needs. For instance, you may want a term policy with a death benefit that could pay off your mortgage and other debts to reduce the financial burden on your spouse or cover your children’s needs in the event you die before they’ve finished their obligations.
Term life insurance doesn’t build cash value, so it isn’t a vehicle for saving or investing. But for most people, it provides sufficient financial protection at an affordable price.