You’ve heard you need life insurance but aren’t sure exactly how it works. Maybe you’ve even put it off (we’ve all been there) but now you’re getting ready to check it off your list. But you’re still wondering, What is life insurance? And what is term life insurance?
Term life insurance isn’t as complicated as you might think. We’ll break down everything you need to know so you can protect your income and your family’s future. We’ll also show you why, in the mysterious land of life insurance plans, term life is definitely your best option.
Let’s dig in!
What Is Term Life Insurance?
Term life insurance (also called pure life insurance) is a type of life insurance policy that lasts for a set number of years, or term. If you die before the term is over, the insurance company will pay the death benefit (also called payout). If you die after the term is over, the insurance company doesn’t pay. Pretty simple.
How much life insurance do you need? Find out with our free calculator!
Life insurance in general is the kind of insurance that takes care of those who depend on your income if anything were to happen to you. With the right policy, you can provide for them even after you’re gone. It’s not a nice thing to think about, we know. But taking the time to figure it all out now is a million times smarter than leaving your loved ones stranded if you suddenly died.
Another thing that sets term life insurance apart from plans like permanent insurance is that it has no cash value. This makes it less expensive because the only value in the policy comes when you’re gone.
How Does Term Life Insurance Work?
So, how does term life insurance work? For starters, it’s a lot like insurance for your car or home. You pay a premium, usually monthly, and the insurance company agrees to pay your beneficiaries in the event you’re not around anymore. It’s essentially a contract between you and the insurance carrier. The insurance company looks at your age, health, life expectancy and a few other factors. And it’s best to get life insurance when you’re young and healthy because the older you get, the more it costs.
Take Steve for example—a healthy, nonsmoking 30-year-old who makes $40,000 a year. Steve’s death benefit is $400,000 because we recommend getting coverage that’s 10–12 times your yearly income. If he dies before his 20-year term is over, the $400,000 will go to his beneficiaries (his wife and two kids). Even though a beneficiary is most likely to be a loved one, it could also be legal guardians, your estate, a charity or a legal trust.
How to Get a Term Life Insurance Policy
There are a couple things to keep in mind as you start to think about getting a rock-solid term life policy in place. We’ll unpack how to get life insurance, specifically term life, so you can know what to expect. These tips will also prevent you from making some of the common mistakes when setting up your policy.
It’s also a good idea to check with your employer to see if they offer a group term life insurance policy. Employer policies usually don’t cover all your needs but they can get you partway there.
After you’ve gotten your quotes and picked the company you want to use, the first step is to actually apply. Depending on your situation, the carrier can say no. They’ll be looking into how much of a risk it will be to them to insure you (technically called an “underwriting” process). Sometimes a medical exam is also required, but some companies now offer no-medical-exam options.
Pick the Length of the Term
We recommend buying a term policy that lasts 15–20 years. This is because if you have young children now, they’ll be able to support themselves by the time the policy ends. So the only coverage you really need is during those 15–20 years in between—when they are fully dependent on your income. And if you don’t have kids (or they’re grown up), that 15–20 years gives you plenty of time to become self-insured (more on that below) and provide for your spouse if something happens to you.
Choose How Much Payout You Need
Here comes the math. (Don’t worry, it’s not calculus or anything.) We recommend taking your annual income and multiplying it by 10–12. The goal is to find out how much money your family would need if you died. Funeral costs, childcare, education for your kids (including college), and your mortgage are the most common expenses to cover. If you’re married, will your spouse work after your death? If so, you may not need to provide as much with another income in the mix.
Your family should have a large enough financial cushion to help them get back on their feet. It also gives them some money to invest, so the interest can provide some extra income. For instance, if they don’t need to dip into the insurance payout, they can invest it in good growth stock mutual funds with a 10% return and that would replace your lost income.
So, here’s the equation: If you make $60,000 a year, multiplied by 10, you would want a death benefit of $600,000.
Now it’s time to name your beneficiaries—the ones who will receive the money. And don’t forget to name a contingent beneficiary. This person would receive the payout if something ever happened to you and the primary beneficiary. It’s kind of like a back-up plan for your back-up plan.
How Is Term Life Insurance Different From Whole Life Insurance?
Whole life insurance is known as permanent life insurance because it’s in place for your whole life (and we hope that’s into your 80s and beyond!). But that’s a lot of premiums to pay—and high ones at that! We’re talking 5–10 times more than a term life premium.
Part of the sales pitch for cash value types of insurance is that they’ll help you build up an investment that could be tapped further down the line. So you overpay in the early years to build up the cash value to offset the increasing cost of insurance in your later years. In reality though, whole life doesn’t compare to term life when it comes to the “making money” part.
Let’s go back to our good friend Steve. He likes to dabble in the stock market, but his insurance agent says if he goes with whole life insurance, his premium will cover his life insurance policy and include investing. What the agent may not tell Steve is this:
The amount Steve makes if he goes with whole life is awful compared to if he went with term life and put some money every month into another type of investment pool (like a good mutual fund). That’s because the rates of return for whole life insurance policies are low compared to the rate of return for something like a mutual fund.
Think of whole life policies as the timeshares of the life insurance industry—a scam to be avoided!
What Are Riders?
Unfortunately, riders have nothing to do with horses or motorcycles in the exciting world of insurance. Riders are extras that “ride” on your regular term policy to serve as an answer to “what if” questions like:
- What if we need to cover unexpected funeral expenses for a member of the family?
- What if I become disabled and can’t pay my premium?
One rider that might be worth having is one that covers funeral expenses for your child. But when it comes to riders like AD&D (accidental death and dismemberment) or critical illness, getting some good disability insurance will cover those things.
And the truth is, you can cover other unexpected costs by building an emergency fund of 3–6 months of expenses, which is one of Dave Ramsey's 7 Baby Steps. Get that going, and you’ll basically create your own “rider” or cushion just by saving and taking control of your money. You don’t need to throw money away to pay for a rider you don’t need. And believe us, you’ll fork out a lot because they’ll jack up your premium to double what it should be.
What Happens When Your Term Life Policy Ends?
If your policy is about to expire, you could renew it for another term depending on your age and life circumstances. If you have a level term plan (more on the types soon) then your premium rate will go up when you renew (since you’ll be older and more expensive to insure). There’s also a chance your premiums could go down if you choose a lower death benefit.
But you should ultimately shoot for being self-insured with an emergency fund by the time your policy expires. It’s easier than you think! If you put 15% of your household income toward investing, you won’t need the death benefit by the time your term life plan ends because you’ll have made a pretty penny in investments.
What Are the Types of Term Life Insurance?
Okay, so here’s where most people want to check out because, well . . . insurance. But as you look into term life insurance, you’ll definitely want to understand the different types:
Level premium (or level term) makes sure the costs stay level based on the length of term you’re after (we recommend a term of 15–20 years). It’s the simplest form of life insurance because once you have it, the premium and death benefit amount don’t change. That’s a nice feeling, isn’t it? This is the main reason Dave recommends level premium term life policies. You know exactly how much it’s going to cost every time your premium is due and can work it into your budget. Could insurance really be this easy? Yes!
Yearly Renewable Term
This policy renews every year and the premium amount increases annually until the term ends to cover the increasing cost of the insurance. Exactly how much it increases is determined by the insurance company when they measure your “risk” every year at renewal time (yikes!). While this can seem cheap during the early years of the plan, the premiums will increase over time and turn out to be higher than if you’d opted for a simple level premium policy.
Decreasing or Mortgage Term
A decreasing term policy is one where the payout decreases over time as your mortgage goes down. The thought is that you don’t need as much of a death benefit if you’re paying down your mortgage. Premiums usually stay about the same, so you end up paying the same every month but with the added “benefit” of a decreasing payout. Not something we recommend.
Return of Premium
This looks good on paper since it’s supposed to give you back the cost of the policy if you survive through the end of the term (and we’re hoping you do!). What about all those premiums you paid? You’ll get them back. But those premiums are much higher in the first place. We’re talking 30–40% higher than a level premium. In the end, it’s not worth it if you’re paying more in the first place.
Guaranteed or Simplified
A guaranteed or simplified term life plan is one you can get without having to mess with a medical exam. You may just have to fill out a medical questionnaire rather than get poked and prodded. And some no-medical-exam policies have become very affordable, so they’re a good option.
Convertible Term Life Insurance
A convertible term life insurance policy is one you can convert to a permanent one down the line. But don’t do it! Your premium will jump way up when it comes time to convert. Some people might convert if they’re coming toward the end of their policy and have a terminal illness, but that’s a rare example.
Voluntary or Group Term Insurance
Your employer might offer group term life insurance as a benefit to staff. They might even pay the whole premium in some cases. Either way, it’s cheap. We’ll always recommend you take the free option, but compare it closely to what you can get on your own before you chip in for it. Also check the death benefit, because an employer payout is usually a lot less than one you took out on your own. And keep in mind that if you change jobs, that insurance doesn’t go with you.
3 Main Benefits of Term Life Insurance
Getting a term life insurance policy may be one of the smartest insurance decisions you can make. Here are three of the top benefits:
Your Family will be Protected
If you and your spouse have young kids, term life insurance is the best way to protect their future and your income if something were to happen to you (God forbid). You’ll sleep better knowing those little ones will be taken care of, along with your spouse.
Term life insurance is some of the cheapest insurance out there. It gives you the best bang for your buck, by far.
Term life has a set time it expires so you’re only paying for the length of time you need it. This means you won’t be wasting money later in life on monthly premiums when you really don’t need the protection anymore.
The Bottom Line
To sum it all up, we recommend a level premium term life policy with coverage that’s 10–12 times your income and a term that’s 15–20 years in length.
Remember, life insurance has one job: to replace your income if you die. It’s there to provide for your loved ones, not to make them rich. You can do that on your own by following the Baby Steps and investing wisely.
If you’re in the market for new life insurance or want to talk to an expert, we recommend RamseyTrusted provider Zander Insurance. Don’t let another day go by without being protected.