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How Does Term Life Insurance Work?

June 27, 2017
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One of the worst things about adulting is that you have to deal with things you never thought about as a kid. Budgeting? Boring and tedious if done incorrectly. Picking a health plan? Hardly what you were thinking of when you dreamed of getting out of your parents' house. But of all those tasks, buying life insurance is one of the more daunting things you'll have to do as a grownup. It's tough to think about death, especially your own, but it doesn't strip you of the responsibility to plan for your loved ones. A few weeks ago we covered how to determine how much life insurance you need. And today, we're going to walk through the basics of the most popular type of life insurance: term life insurance. Let's get started!

What Is Term Life Insurance?

At the risk of being redundant, term life insurance is temporary coverage, or insurance that covers your family if you die within a certain term of time. I like to equate term life insurance to renting a home. If you sign a lease for 12 months, you get to live in that home and experience all of the benefits that come with your agreement. You don't have to wait until the end of the 12th month to experience those benefits; they're available to you from the minute your lease is active. Term life insurance works the same way; most companies offer policies for 10, 15, or 20 year terms. This means that if you die at any point within the agreed-upon term, your family will receive a death benefit. It doesn't matter if that death comes in the last month of the last year your policy is active, or in the first month. Your family will get the money as long as you die within the agreed-upon term.

Is Term Life Insurance Affordable?

Affordable is relative. Life insurance is priced based on your age, health, and the amount of coverage you want at the time you apply. Term life insurance is typically the most cost-effective type of life insurance you can buy, which is why it's so popular. If you think about it, the insurance company is going to look at the term you're purchasing and try and figure out how likely you are to die within that period of time. The lower your risk of dying, the less risk that the insurance company having to pay the claim, which means they can charge you a relatively small amount and still make a profit. For example, a 30 year old and a 60 year old both buy $500,000 policies for a 10 year term. Just based off of age, the insurance company will charge the 30 year old far less for their coverage. Why? Because statistically, they are less likely to die within 10 years than a 60 year old. In the coming weeks we'll also cover permanent life insurance which, unlike term insurance, doesn't expire. Term life insurance is more cost-effective than permanent insurance because you could potentially pay your premiums for the entire term and not die, meaning the insurance company never even had to pay the claim. But with permanent insurance, it is active until you die, and unfortunately none of us are getting out of this life alive. Because of this fact, insurance companies charge more for permanent coverage for term because they know that eventually they will have to pay a death claim.

What Happens When Term Life Insurance Expires?

There are three options when your term life insurance expires:

  1. Keep the policy and pay higher premiums: let's go back to the rent analogy: if your lease ends and you have nowhere else to go, what can you do? Well, if you can't qualify for a new lease, you may stay where you are and pay month to month rent, which is typically much higher. Term insurance works similarly; if your term expires and you can't qualify for a new policy, likely because of health concerns, you can keep your policy even though the term has expired. The good news here is that you would still have coverage. The bad news is that the price the insurance company offered you was only good for your original term. So if you keep it active after expiration, your premiums could skyrocket. This is not an ideal option at all.

  2. Apply for a new term with your current company or a new company: assuming you're still in good health, you can apply for a new term insurance policy with your current company. You might also "shop" your rates and find that there is a better option out in the marketplace. Remember, however, that your health isn't the only factor in the cost of term life insurance; age plays a factor as well. So even if you are in great health, you can expect to pay more if you're looking for insurance coverage 10, 15 or 20 years after purchasing your last policy. Statistically speaking, you're now more likely to die (morbid, right?), so the insurance company will increase your costs accordingly. Term life insurance can still be effective in later ages, but you always want to keep an eye on rates. You don't want to be 65 or 70 and having to apply for a new term policy. I can assure you, at those ages the rates will not be so kind. To avoid that trap, you might want to consider option number 3.

  3. Convert to permanent coverage: permanent coverage is another topic for another, more complex day. But the fact is, permanent life insurance can be a great tool if used properly. While it is a significantly higher cost than term insurance, permanent insurance has a number of financial benefits available to policy owners which aren't offered by term policies. And even if you're not doing it for your own financial benefits, converting at least a portion of your coverage to permanent life insurance can ensure that you have an amount of protection that won't expire. Many of us think that we'll get to a point where we have no need for life insurance. Unfortunately that is rarely the case in our society. Permanent life insurance can shield you from the risk of needing coverage and not being able to afford or qualify for a new term later in life, but it should only be purchased with a thorough understanding of the ins and outs.

How Do I Know If Term Insurance Is Right For Me?

  • Your needs will decrease over time: some of the things you need life insurance for right now might not always be a part of your financial picture. Insurance needs can evolve for the young and old alike. For younger families especially, insurance needs can peak for a period and then decrease significantly over time. Maybe you have kids in the house that you would want to provide for now, which might mean you need a large insurance policy. But as they grow, the amount of time you need to protect them decreases, and so does the money needed to do so. When they leave the house, maybe now the only person you need to protect is your spouse or your grandkids. Term life insurance makes sure that you have access to affordable coverage for the period of time that it is needed.

  • Your needs outweigh your money: who hasn't found themselves in this situation? To be blunt, there are a lot of things you might want for your family that you simply can't afford to provide. And if these are serious needs, there is a big risk that you might die before you can save the money on your own. Rather than facing an uphill battle that you might not be able to win, term life insurance can shift that risk to the insurance company.

  • You have debts that your family would inherit: the last thing you want to be is a burden to your family after you die. If you have a debt obligation that would be passed onto a family member, such as a mortgage or a personal loan, you can purchase term life insurance for the length of your debt agreement. For example, if you have 20 years left on your mortgage, you could buy a 20 year term policy to cover your family in the event that you die.

There are a host of other reasons why people need life insurance and why they purchase coverage, but this is a great place to start. If you know you have a need, or found out that you have one today, feel free to contact us for help in securing coverage. Or if you have a local advisor you trust, reach out to them for help walking through the different options available to you: however you get it, we want you to have the coverage you need! Stay tuned for future posts and we'll provide more insight on what to look for in your term policy, and if you have a topic you'd like to hear more about, fill out our questionnaire and we'll try our best to get to it!