Updated May 17, 2019

What Is Term Insurance and How Does It Work?

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Term life insurance is a simple concept, but there are many different types. Read on to learn the different types, how they work, and pros and cons.

What Is Term Insurance?

Term life insurance is the simplest and least expensive type of life insurance.

You pick a term length, buy the policy, pay the premium, and the beneficiary receives the death benefit if you die during the term. That's it!

If you don't die during the term, the policy will usually just expire and that's it. But there are convertible or renewable options if you still need insurance.

When you buy term insurance, you choose the:

  • Length of the term

  • Death benefit (how much you want to leave the beneficiary)

  • What happens at the end of the term (convertible or renewable options)

It's best to choose an affordable, convertible policy with enough death benefit to provide for your family's needs. Shorter terms are less expensive. If your budget is tight, it's better to shorten the term instead of reducing the death benefit.

Pros of Term Insurance

  • Simple to Understand
    There aren't many moving parts. Just pick the coverage amount and the length of the term.

  • It's Affordable
    It's not expensive to buy a high amount of coverage. Families can buy as much insurance as they need. For example, a healthy 30-year-old man can buy a 30-year-term with $500,000 coverage for as low as $35/month.

  • Flexibility
    Conversion options make term insurance a surprisingly flexible option.

Cons of Term Life Insurance

  • Coverage is Temporary
    You're only covered for the length of your term, which most people outlive. If you need insurance even if you die at a later age, consider whole life or guaranteed universal life.

  • No Investment Portion
    If you outlive your contract, it expires and that's it. It can seem like a waste to have paid for multiple years.

    Whole life policies, on the other hand, have a cash value savings component that you can use while alive. This could be a good option for people who wouldn't save otherwise. If you won't invest separately, a policy that builds cash value may be a better choice.

  • Higher Premiums if you Need to Renew
    If you outlive your contract and still have insurance needs, you'll have to renew, but this time at a higher premium. You'll be older and may have more health issues, so it'll likely be more expensive.

Who Should Buy Term Insurance

Term insurance is best if you only need coverage for a certain period. It's ideal during the period when most families have financial obligations and won't be able to cope with the loss of one income. Those times often include:

  • Before your children complete college and become self-sufficient.

  • If you have a mortgage that consumes a large portion of the family income.

  • If you don't have enough of a nest egg to provide financial stability if one parent dies prematurely.

For example, if your kids are toddlers, you can just get a 20-year term insurance policy. This will cover your family until your kids graduate college.

Types of Term Insurance

You pick a term length when you buy the policy. During the term, the policy will maintain the same premium. The basic rule is that the longer the term, the higher the premium.

  • Annual Renewable Term
    An Annual Renewable Term (ART) will be the lowest cost option initially. But the cost rises each year because the premium renews at a higher rate. ART is a good choice when you're not sure how long you'll need coverage.

  • 10-year Term
    Ten-year term is the least expensive of the longer-term options. This can be a good choice if you have a tight budget now, and expect your income to be higher in 10 years.

  • 20-year Term
    A twenty-year term policy is great for a complete family (when all the children are already born). By the end of the term, the children will be grown and less insurance will be needed.

  • 30-year Term
    This is a good choice if you have just taken out a 30-year mortgage and want insurance to cover it. Also, it's good if your family has a strong history of developing illnesses that affect life expectancy. It will lock in rates at your current health status for three decades. This will provide peace of mind.

  • Decreasing Term
    The death benefit declines over the length of the term. This can be a good choice if you want insurance to pay off loans, like a mortgage. The death benefit declines as your loan balance declines. This way, you aren't paying for more insurance than you need. This is usually cheaper since the death benefit decreases.

  • Renewable Term
    This allows you to renew without going through underwriting. But when you renew, it'll be at higher premium rates. Policies usually renew for a specific term, such as 5 years. This is good if you only need coverage for a short period of time for now, but want the option to extend it.

  • Convertible Term
    This allows your term policy to be converted to permanent insurance without re-evaluating your health. This is good if you'll need permanent insurance later on but can't afford the premiums.

It's smart to buy a convertible term as an inexpensive way to leave options open. Changes in health status, occupation, or hobbies may make qualifying for insurance at the end of the term more difficult. A convertible term policy will let you convert your term policy at the health status you had when you bought the term policy.

  • If you qualify for a new policy at good rates, you won't use the conversion feature.

  • If you've taken up dangerous hobbies or been diagnosed with an illness that can shorten life expectancy, you'll want to convert the policy.

Conversion privileges are not the same at every life insurance company. Some companies require you to convert to their Cadillac policy with expensive premiums while others give you the ability to choose the type of policy you buy. Choose the term policy that has the best conversion option and lowest premiums at a financially-sound life insurance company.

  • Simplified Issue
    Usually, you need to take a medical exam so the insurance company can determine your risk and premium. With simplified issue, you don't need to take the medical exam, so it's easier to get, but more expensive. This is only a good choice if you think you won't pass the exam or won't qualify for a low premium.

Difference between Term and Whole Life

  • Whole life insurance lasts for your entire life:
    As long as you keep paying the premium, the insurance company will provide a payout upon your death, no matter when you die.

  • Whole life policies have a cash value component
    This is similar to a savings account within the policy. The amount grows as premiums are paid. You can borrow from it if you need money (such as sending kids to college). If you terminate the policy, you get the cash value amount. At age 100, the cash value will equal the death benefit.

  • Whole life insurance is very costly
    For a $500,000 death benefit, the monthly premium for a healthy 30-year-old man could be $400/month. That's over 10x the cost of term insurance.

  • Usually only needed for special circumstances
    Most people don't need whole life. Usually it's for situations such as:

    • If you need to pay estate taxes
    • To fund business buy/sell agreements
    • To provide for a special needs child

If you do not have specific needs that require a whole life policy, you are better off buying term. If you want to save or invest money, it's better to just buy term and invest the difference separately. You can get better returns. Qualified retirement accounts provide the opportunity for deferred growth of your savings and investments.

Difference between Term and Universal Life Insurance

Universal life offers more flexibility, but is more complicated.

  • Universal life has variable cash values
    Cash values vary based on the interest rate declared by the insurance company, so this can offer better returns than whole life policies when interest rates are high. But cash values are not guaranteed.

  • The annual premium is flexible
    You can pay flexible premium amounts (within minimums and maximums). If you have enough cash value, you can even use it to pay the premium. But the insurance company can increase premiums if interest rates are low.

  • You get more of a choice
    You can choose how much of the premium you want to go into the death benefit and how much to go into cash value.

It's important to take time to understand how universal life works. Some mistakes include: underfunding (which causes the cash value build-up to be too low), skipping payments, low interest rates negatively affecting the cash value, and the company's ability to increase the premium.

Common Mistakes to Avoid

Be careful of these common mistakes when buying term life insurance.

  • Not buying enough insurance
    Most people don't buy enough. Paying off debts, replacing your income, and funding your children's college education add up. Parents in a typical family should buy life insurance that equals 7-10 times their annual income. Term insurance is cheap, so buy enough to cover all your family's needs.

  • Multiple policies when one will do
    Some agents encourage you to buy more than one policy. For example, they might suggest you buy a $500,000 policy for ten years and another $500,000 policy for twenty years. The suggestion seems to make sense when you need more insurance now and less later.

    It may not make sense, though, because every term insurance policy has a flat rate "policy fee" of $50 or more baked into the premium rates, which offsets a lot of the difference between ten- and twenty-year rates. Compare both options.

  • Overpaying for simplified issue
    Simplified issue means you don't do a medical exam when you purchase the policy. Because it's easy to get, it's more expensive. This is only a good move when you are worried something discovered during the process will increase your rates.

    If you're worried about this, buy a simplified issue policy so you have coverage quickly. Afterwards, apply for a fully underwritten policy. If you're able to obtain the underwritten policy at a lower rate, cancel the simplified issue policy and keep the less expensive coverage.

  • Not understanding the conversion privilege
    Does your term policy have a conversion option? A conversion option will provide a good alternative if you are not insurable at the end of the term. Strong financial ratings should be given a high priority when you choose the company where you buy life insurance.

  • Not using an independent agent
    Independent agents have access to many different companies. Each company has different rates, areas of specialty, and conversion options. The areas of specialty are critical if you have a health issue, occupation, or hobby that makes qualifying for good rates difficult.

Question to Ask When You Shop for Term Insurance

  • How long do I need coverage?
  • How much coverage do I need? How is this determined?
  • Is the policy convertible?
  • What types of policies can it be converted into and what would the premium be if I convert?
  • What happens if my health changes?
  • Are there any exclusions (are any activities excluded)?
  • What happens if I miss a payment? Is there a grace period?
  • How financially sound is the insurer?

Bottom Line

Term insurance is an inexpensive way to provide for your family if something were to happen to you. It's the best choice for most families because it's simple and affordable. Pick a term that would cover the length of your major financial obligations (like a mortgage). Remember to ask questions and understand your policy before you buy.

More from CreditDonkey:

What is Life Insurance

Types of Life Insurance

How Does Life Insurance Work?

More Articles in Money Tips

Life Insurance

Term Life Insurance Rates by Age

Term life insurance is an affordable coverage option for many. But is it the right choice for you? Keep reading to find out.

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