Table of Contents
Life Insurance Guide
What is Life Insurance
Life insurance is a contract between the policy owner and the insurance company. In exchange for your premium payments, the insurer agrees to pay a set amount of money (a death benefit) to the designated beneficiary after the insured policy owner dies. Your beneficiaries can use the money for anything they choose. This often includes:
- Paying living expenses
- Paying a mortgage or settling other financial obligations such as outstanding loans and debts
- Paying for a child’s higher education or covering childcare costs
- Putting money aside for retirement
- Making a payment for funeral and estate fees
When it comes to choosing how long you want the coverage, there are two main types of life insurance: term and permanent. Term life insurance provides coverage only for a specific period of time; permanent life insurance, on the other hand, provides coverage for a lifetime with a savings component that builds cash value over time.
Term Life Insurance
Term life insurance is a type of insurance policy that provides coverage for a specific period or term, usually 5, 10, 15, 20 or 30 years. If the insured policy owner dies during the term period, the named beneficiary receives a death benefit as long as the premiums have been paid throughout their lifetime. If the policy owner lives past the term, the policy expires, and they are no longer covered. There are five different types of term life insurance:
- Level term insurance: This type of term policy is the most common and offers a death benefit that remains the same throughout the policy. As the death benefit does not change, the premiums remain stable.
- Increasing term insurance: This type of term policy offers a death benefit that increases throughout the policy. The premiums may increase.
- Decreasing term insurance: This type of term policy offers a death benefit that decreases over the duration of the policy, usually in one-year increments. The premiums decrease over the length of the policy. Because the payout decreases over time, decreasing term policies are generally less expensive than level term insurance.
- Yearly renewable term (YRT) plans: This type of term policy offers coverage for one year. The premiums are lower initially but increase when you renew coverage.
How Does Term Life Insurance Work?
Term life insurance is the simplest form of life insurance agreement where the policy owner agrees to pay premiums and, in return, the insurer guarantees to pay a death benefit if the insured policy owner dies during the term of the policy as long as the premiums are paid. However, if the policy owner outlives the policy’s term, there is no payout. The policy expires at the end of the term, and so does the life insurance coverage. Before the policy comes to an end, you may be able to convert it into permanent coverage, renew it for another term, let the policy expire, or purchase a different policy. If you choose to renew the term policy, the premiums are recalculated for your age at the time of renewal. You choose the term when you purchase a term life insurance policy.
Choosing a Term Length
Here are some of the most common term lengths to choose from:
- Annual renewable term (ART) insurance: This type of term policy offers a guaranteed renewal of coverage each year for a set number of years without having to reapply or take another medical exam.
- 5-year term life insurance: Including annual renewable term (ART) insurance, 5-year term life insurance is one of the shortest term insurance policies available that offers coverage for a period of five years.
- 10-year term life insurance: This type of term policy offers coverage for a period of 10 years. At the end of the policy term, the policy owner may be able to renew coverage, convert it to permanent life insurance, typically at higher monthly premiums, or let it lapse.
- 20-year term life insurance: This type of term policy offers coverage for a period of 20 years. At the end of the policy term, the policy owner may be able to convert it to permanent life insurance, typically at higher monthly premiums, or let it lapse. However, some 20-year term policies may offer an option to renew on an annual basis until 95 years of age.
- 30-year term life insurance: This type of term policy offers coverage for a period of 30 years. At the end of the 30-year term, the policy expires. The policy owner either can remain without coverage or apply for a different policy for needs at that age.
How long do you need life insurance for?
Dave Ramsey, one of the most trusted voices in personal finance, recommends a policy with a term of 20-30 years, depending on your and your dependents’ ages. This way, your coverage will extend through some of life’s major milestones, like your mortgage getting paid off, kids going off to college or getting married.
Here’s a quick rundown of some things to consider when making your decision:
- How much debt do you have?
If you have a mortgage or other significant debts, your family will need enough life insurance to pay them off in the event of your death.
- What is your income?
Your family will need for life insurance long enough to replace your income if you die. Be sure to factor in things like inflation and future earnings potential when making your calculations.
- What are your children’s needs?
If you have young children, you’ll need to make sure they’re taken care of financially if something happens to you. This includes things like education and child care expenses.
- What are your other financial obligations?
If you have any other financial responsibilities – such as caring for an elderly parent or supporting a disabled sibling – you’ll need to make sure those obligations are covered by your life insurance policy.
Who Needs Term Life Insurance?
A term life policy is the simplest, most affordable type of life insurance, but it is not for everyone. If you have debts to pay off, retirement savings to build up, or if you are a business owner, term life insurance can be an intelligent choice. If you have dependents who will need financial support after you die, a term life insurance policy is a great way to ensure they are taken care of.
- If you have children or dependents
If you’re no longer around to support your loved ones, they can use the payout to pay your mortgage balance, outstanding debts, and cover your funeral costs.
- If you are pregnant or planning to have a baby
If you’re pregnant or have a baby on the way, it’s essential to make sure you have coverage in case something happens to you. Your partner will need money to be able to afford childcare while they work, so life insurance is a must-have for any parent-to-be.
- If you support aging parents financially
Life insurance is a must if you have aging parents relying on you for financial support. A good policy with a long-term care rider can help defray the costs of caring for your loved one.
- If you have a student loan
In the event of your death, your parents can use the life insurance benefit to pay off your outstanding debt, so your parents or other family members won’t be left with that burden. Life insurance can give them peace of mind and help them maintain their standard of living.
- If you are a key member of your family business
Long-term care and disability riders are an essential part of the life insurance of any prudent business plan. If a key business member dies or becomes disabled, the life insurance policy with disability riders can help keep the business afloat financially. Naming the business as the beneficiary ensures that the company can continue to operate in the event of a tragedy.
- If you have a high-risk job
Because some high-risk environment jobs carry a greater chance of death than those working in a desk job, life insurance companies reflect consider this as a higher risk to insure. Suppose you work in aviation, construction, firefighting, mining, oil, natural gas, or other high-risk occupations. In most cases, you can expect to pay higher premiums for your life insurance.
- If you participate in dangerous hobbies
While life insurance is a crucial part of financial planning, it’s also important to be honest about your lifestyle and activities when you apply for a policy. You should disclose on your application if you have an extreme hobby like rock climbing or scuba diving. Otherwise, the insurance company may decrease the death benefit or cancel the policy if you die within the first two years.
- If you are a stay-at-home parent
Term insurance is also an intelligent choice for stay-at-home parents, whose unpaid work is crucial to the family’s well-being. It can help ensure that your family is taken care of financially and can continue living in the comfort of their home in case the unexpected happens.
- If you are a single parent
As a single parent, you have a lot on your plate. You’re responsible for everything from childcare to bills and everything in between. You can use term life insurance to cover unexpected expenses, save for your child’s education, or even fund your retirement. And because life insurance is portable, you can keep the same policy even if you change jobs or move to a new city.
- If you are a homeowner
Term life insurance policy is most suitable for mortgage protection and one of the smart investments you will make to protect your family’s home in the event of death. The death benefit will pay off the remainder of your mortgage so your loved ones can continue living in the comfort of your home. It also ensures enough money is left to help maintain your family’s lifestyle, pay off other debts, and cover your final expenses.
Term Life Insurance: Pros and Cons
Though term life insurance is often an excellent option for many people, here are some pros and cons of it to help you decide if it’s the right fit for you.
The main benefits of purchasing a term life policy are:
- Affordable: Term life is generally much cheaper than permanent life insurance, making it an excellent choice for people on a budget but who still want to have some financial protection for their loved ones.
- Simple: Term life insurance is the most straightforward type of policy, making it an excellent choice for busy families. Because there are no complicated terms, cash value, and other features to manage or conditions to understand, term life is easy to carry and understand.
- Flexible: Term life insurance is flexible. You can select the length of the term (typically 5 to 30 years) and choose the amount of coverage you need. Also, if your needs change over time, you can constantly adjust your coverage.
- Tex-free death benefit: Term life insurance provides a tax-free death benefit to your beneficiaries.
- Easily approved: Most companies nowadays offer term policy through a process called accelerated underwriting that relies on a phone screening process to verify your answers to the life insurance application questions and data analytics to assess the risk of applicants, thus enabling you to skip the medical exam as well as receive a decision faster typically in a matter of minutes as opposed to traditional underwriting which takes a couple of weeks to months. You could get approved within a couple of hours if you’re in good health.
While term life insurance is usually the way to go, there are some drawbacks to buying a policy that only covers you for a set period. For example, a term policy does not build up any cash value over time. Additionally, if you must renew your policy when it expires, your premium will be adjusted based on your current age and health – which could mean much higher rates.You may not qualify for no-medical term life insurance if you have serious health issues.
But despite all these potential drawbacks, term life insurance can still be an excellent option for many people.
Why do you need life insurance?
Most people who know about life insurance don’t really understand why it is important. Sure, it seems like an obvious choice to make sure your loved ones are taken care of financially if you die unexpectedly. But there’s more to it than that. Life insurance can provide peace of mind and financial security in a variety of different situations. Here are a few of the many reasons why you should have life insurance:
- To cover final expenses – If you die without life insurance, your family will be responsible for covering your final expenses, which can add up to thousands of dollars. Life insurance can help relieve the burden on your loved ones and ensure that your final expenses are taken care of.
- To pay off debts – Life insurance can help make sure that your family is not left with a heavy debt burden after your death.
- To replace lost income – If you are the breadwinner for your family, your death could leave them in a difficult financial situation. Life insurance can help replace your lost income and make sure that your family is taken care of financially if something happens to you.
- To fund education costs – If you have young children, life insurance can help fund their education costs. This can be a huge financial relief for your family and ensures that your children will be able to get the education they need even if something happens to you.
- To cover business expenses- If you own a business, life insurance can help cover the costs of things like payroll and other business expenses if something happens to you. This can help keep your business running smoothly after your death and prevent financial hardship for your family or employees.
How much life insurance do you need?
The amount of coverage you need depends on many factors, including your age, health, income, and family situation. But there is a helpful rule of thumb that can give you a good starting point: the DIME formula. DIME stands for Debt, Income, Mortgage, and Education expenses.
D = Debts and final expenses
This includes your car payments, credit card balances, personal loans and any other outstanding debts. It should also include an estimate of your final expenses, such as funeral and burial expenses and any outstanding medical bills.
I = Income replacement
The income replacement benefit is the amount of money your family will need to replace your income if you die. This should be enough to cover things like living expenses they may have. Your life insurance policy should cover at least 5-10 years of your income.
M = Mortgage protection
The mortgage protection benefit is the amount of money your family will need to pay off your mortgage if you die. This should be enough to cover the remaining balance on your mortgage.
E = Educational expenses
The education benefit is the amount of money your family will need to pay for your children’s education if you die. This should be enough to cover things like tuition and other related expenses.
To use the DIME formula, simply add up all of your debts and final expenses, then add up how much income you would need to replace if you died. Next, add the amount of your mortgage that would still need to be paid off if you passed away. Finally, estimate the cost of your children’s education. The total amount is the amount of life insurance you should carry.
Here’s an example: Let’s say you have a $200,000 mortgage, $50,000 in other debts, and you earn $75,000 per year. Using the DIME formula, you would need a life insurance policy worth at least $1 million.
This is just a starting point. You may need more or less coverage depending on your unique circumstances. But the DIME formula is a great way to get a ballpark estimate of how much coverage you need.
How much does life insurance cost?
The cost of life insurance varies depending on a number of factors, such as your age, health, lifestyle, and the type and amount of coverage you’re looking for. However, here are some estimates you can use to get an idea of what you might expect to pay.
For example, a healthy 30-year-old woman who wants $500,000 in term life insurance can expect to pay around $22 per month for her 20-year policy. The same 30-year-old woman who wants $500,000 in permanent life insurance can expect to pay around $235 per month for her policy.
Glossary of Life Insurance Terms
Beneficiary: The person or entity named in a life insurance policy to receive the death benefit.
Coverage: The amount of financial protection given by an insurance policy.
Death benefit: The amount of money paid out by the insurance company to the beneficiary when the insured person dies. A death benefit is not subject to income tax and named beneficiaries receive the death benefit as a tax-free, lump-sum payment up to the policy’s limit.
Face value: The face value of the policy is the amount of money the insurer agrees to pay the designated beneficiary when the policy owner takes out the policy.
Insured: Insured is the person or the policy owner who is covered against risk.
Policy owner: Also known as the insured. The person who owns the life insurance policy and pays the premiums. The policy owner can also be the insured person.
Insurer: The insurer is the insurance company that is providing coverage.
Premium: The monthly or annual payment made to keep a life insurance policy in force.
Cash value: This is money that accumulates in your permanent life insurance policy that can be accessed through loans or withdrawals. Not all policies have cash value.
Policy Term: This is the length of time that your life insurance policy will be in force. Common policy terms are 10, 20, or 30 years.