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What Is Life Insurance?

The actual concept of life insurance is super simple. Life insurance is an agreement between you and an insurance company. You pay them a monthly payment, and if you die, the insurance company agrees to pay a specific amount of money—a life insurance payout—to whoever you choose.

Makes sense, right? Doesn’t everyone with loved ones who depend on them financially have life insurance? You’d think so, but tons of people don’t.

Here’s the deal: If anyone depends on the money you bring in, you need life insurance. Today! If you’ve been putting it off because you’re not clear on how it works, that ends now. We put together everything you need to know about life insurance—how it works, which type is right for you, and how much it costs—so you can get this taken care of right away.

How Does Life Insurance Work?

Here’s a bird’s-eye-view answer to the question, “How does life insurance work?”

Paper and Pencil

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Life insurance has one job—to replace your income when you die. Think about it: If you unexpectedly pass away, how will your family pay their living expenses without going into major debt? Life insurance removes that risk—and gives you and your family peace of mind. With this protection in place, you know that if the worst happens, your family will be okay financially.

Like we said in the beginning, the concept of life insurance is simple. The process of getting life insurance is a little more complicated. That’s because the industry has muddied the waters with all kinds of jargon and more types of life insurance than you can shake a stick at.

But we’ll walk you through all that stuff—and even go over what you should know to file a claim for a death benefit. First, let’s go over the life insurance terms you need to know.

Life Insurance Terms to Know

Have you come across a lot of confusing jargon while trying to find out about life insurance options? Breathe. You only need to know a few common terms to really understand how life insurance works:

Pretty simple stuff, right? Now let’s dig into the really important stuff.

Do I Need Life Insurance?

Like we mentioned, if anyone in your life depends on you financially, you need life insurance. Depending on where you are in life, how much you need can look really different. So, let’s talk about your life insurance needs based on different life stages.

Young Professionals

If you have credit card or student loan debt that’ll need to be paid if you die unexpectedly, you need enough life insurance to take care of that. But if you’re completely debt-free with no kids (or other dependents), then all you really need to worry about are burial costs. And if you’ve signed up for a group life insurance plan through your employer, you’re probably covered. No need to take out your own policy—yet!

Newlyweds

Congratulations! You’ve just started your new life together, and that means you’re there for each other through thick and thin. But till death do us part isn’t the end of the discussion. You should both have a life insurance policy in place.

This isn’t just about paying off debts if one of you passes away—it’s about protecting and providing for the future of your spouse as they grieve your loss. Get enough life insurance to make sure they’re taken care of. (We’ll get into the details of exactly how much in a minute.)

Parents

If you have children, both you and your spouse need to be covered, even if one of you doesn’t work outside of the home. The loss of a stay-at-home parent would still hurt the family budget. Childcare costs aren’t cheap.

Consider what it would take to run the household, provide for your kids (including college), and possibly pay off your home in the years following your death or the death of your spouse. Trust us—the right life insurance will provide the peace of mind you want (and need).

Retirees

At this point, you might already have hefty retirement savings. You could even be well on your way to becoming self-insured. That’s a great place to be!

But let’s say you’re still paying off your house and trying to add to your retirement savings. If you died today and your spouse no longer had your income to rely on, would the amount in your savings be enough to take care of them? Remember, the whole purpose of buying life insurance is to replace your income if you die.

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Main Types of Life Insurance

While there are all kinds of life insurance policies, they all fall into two main buckets: whole life (pretty much the worst option) and term life (which we always recommend).

Why are we such big fans of term life insurance? The reasons are really simple:

  • It’s the least expensive type of life insurance.
  • It does the one thing life insurance is supposed to do—replace your income when you die.
  • It provides coverage for a specific amount of time—long enough for you to become self-insured.

Whole life insurance is what’s known as permanent life insurance because it does exactly what the name implies—it provides coverage for your whole life.

That might sound like a good deal. But trust us, it’s not. All forms of whole life insurance try to combine two goals (life insurance and savings) into one product. The thing is, it doesn’t do either very well. It’s way more expensive than term life insurance and the savings side of whole life policies almost always falls short because you end up paying so many fees.

And that’s not even the worst part. If you keep the policy until you die, your family receives the death benefit on the policy, but any savings you managed to build up go to the insurance company. Yep—your family won’t see any of it. If that sounds like a scam, that’s because it is.

That’s why we recommend term life insurance for everyone who needs life insurance. Now let’s talk about how much insurance to get.

How Much Life Insurance Do I Need?

When you buy your term life insurance, look for a level term policy that lasts 15–20 years and covers 10–12 times your annual salary. So, if you make $100,000 a year, buy a term life insurance policy between $1 million and $1.2 million.

That sounds like a lot. But the idea is, if something happens to you in that 15–20-year time period, your family can invest that death benefit in good growth stock mutual funds. Then they can use the growth of that investment to replace your income year after year.

How much term life insurance do you need?

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How Much Does Life Insurance Cost?

Now for the fun part. How much should you expect to pay?

The cost of a life insurance policy depends on the type you’re buying (whether it’s term life or whole life), but other details play a role too. Insurance providers use all these factors as they tally your life insurance premium:

  • Age
  • Gender
  • Personal and family medical history
  • Weight
  • Tobacco use
  • Risky hobbies, like skydiving or shark wrestling
  • Regular travel to dangerous parts of the world

Your age and your health are two of the biggest factors that affect the cost of your life insurance policy. We put together a chart to help you get a feel for how much you can expect to pay for a $1 million nonsmoker policy based on age and term length.

Most policies require you to get a medical exam, but you can find life insurance options that don’t involve a medical exam.

How Do Life Insurance Payouts Work?

If you ever have to make a claim on a life insurance policy, you can be sure it won’t happen at an easy time. Knowing some of the basics of how life insurance payouts work can help make things less stressful. Here are a few things you should know:

  • How do you contact the insurance company? When you need to make a claim, you can contact the life insurance company.
  • What paperwork will you need? The beneficiary is required to provide the insurance company a certified copy of the policyholder’s death certificate, either through the hospital or from the county or municipality where they died.
  • When should you make a claim? There’s no time limit for filing a claim for a life insurance payout. You can take care of it on your own timetable when you and your family are ready.
  • When will you receive the payout? Life insurance benefits are usually paid within 30 days after the insurance company receives all the right documents.
  • What taxes will you owe? Life insurance payouts are tax-free!

How Do I Buy Life Insurance?

Let’s make this simple. There are basically three decisions to make when you buy a life insurance policy:

  1. What type?
  2. How much?
  3. How long?

We can answer the first two questions for you: Always buy term insurance and get 10–12 times your annual income. We can help with the third question too, but the final answer is up to you. Here’s why.

Most folks will do best with a term life policy that lasts 15–20 years. That way, if you have young children, they’ll be out of college and able to support themselves by the time the term life policy is over.

If you’re following our Baby Steps, you’ll be busy building an emergency fund and investing your money in mutual funds during those 15–20 years. So by the time your term life insurance plan is over, and won’t need life insurance.

Get the Right Coverage and Excellent Service

There’s one more thing you need to know about life insurance: The longer you wait to buy it, the more expensive it gets (unless you found a way to age backward!). Don’t put it off.

Ready to get started? We recommend RamseyTrusted provider Zander Insurance. Their insurance experts can give you a quick, free quote on a term life policy in a few minutes.

Get your term life insurance quotes today!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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Get Your Numbers

How much life insurance do you need?

Find the best term life policy for you with our free life insurance calculator.
Get Your Numbers