Originally designed to help cover burial costs and care for widows and orphans, life insurance is now a flexible and powerful financial product. Over half of Americans have some sort of life insurance, according to insurance research organization LIMRA.
By definition, life insurance is a contract between you and a company. In exchange for regular payments to the company, it pays out money upon your death. There are two main types: term life insurance and permanent life insurance. Term life covers you for a fixed amount of time while permanent life insurance covers you until the end of your life.
Generally, term life insurance is cheaper to purchase than permanent life. However, permanent life policies, like whole life, build cash value over time and always pay out. Term life policies have no value if you outlive the contract.
Life insurance can be issued as either individual or group policies. Here, we’ll be looking at individual policies, not the group life insurance commonly issued through work.
Who needs life insurance
Like all insurance, life insurance was designed to solve a financial problem. When a person dies, their income disappears and someone has to pay for the burial or other expenses, usually a spouse, child or another relative.
The people or organizations that receive the life insurance payout when you die are called your beneficiaries. As you think about the amount of life insurance coverage you need, consider those beneficiaries and what they’ll need.
If you don’t have anyone depending on your income and your funeral expenses won’t be a burden on your loved ones, life insurance may be a thing you can skip. But if your death will be a financial burden on your loved ones, you may need a life insurance policy.
How much life insurance do you need?
The amount of life insurance you need depends on what you’re trying to accomplish. If you’re just covering end-of-life expenses, you won’t need as much as if you’re trying to replace lost income. The calculator below can help you estimate the total coverage you may need.
If you’re interested in a permanent policy (more on these below), you should also connect with a fee-only financial advisor who can help you understand how a policy can fit into your financial plan.
How term life insurance works
Term life insurance lasts for a period of time defined at purchase. Policies commonly cover 10-, 20- or even 30-year periods. If you die during the covered period, the policy will pay your beneficiaries the fixed amount stated in the policy. If you don’t die during that time frame, no one gets paid.
Term life is popular because it offers large payouts at a far lower cost than permanent life. It’s also a temporary solution. It exists for the same reason temporary tattoos and hair dyes do — sometimes a little while is long enough.
Reasons you may want term life insurance include:
- You want to make sure your child can go to college, even if you die.
- You have a mortgage that you don’t want to saddle your spouse with after your death.
- You can’t afford the higher premiums of permanent life insurance and still want coverage.
There are some variations on typical term life insurance policies. Convertible policies allow you to convert them to permanent life policies at a higher rate, allowing for longer, more flexible coverage. Decreasing term life policies have a decreasing death benefit over time, often lined up with mortgages or large debts.
How permanent life insurance works
Permanent life insurance covers you until death, assuming you pay your premiums. The most well-known version of permanent life is whole life insurance, but there are other flavors of permanent life including universal life and variable life.
Permanent life insurance policies build cash value as they age. A portion of the premium payments is added to a cash account, which can earn interest or be invested, depending on the type of policy you hold.
Cash value usually rises quickly at the beginning of a policy’s life, when you’re younger and cheaper to insure. Whole life policies increase their cash value at a fixed rate, while universal policies fluctuate with the market. It takes time to build the overall cash value in these accounts, which you should consider when buying life insurance.
You can then use the cash value while you’re still alive. You can borrow from it, make withdrawals or just use the payments to cover your premium later in life, depending on what your policy allows. You can even surrender the policy, trading your death benefit for the value currently in the account, minus some fees.
All of these options come with potentially complex tax implications, so make sure you talk to a fee-based financial advisor before tapping cash value.
Whole life insurance
Whole life policies, with their guaranteed payouts, potential cash value and fixed premiums, sound like great products, but that all comes at a cost — cash. Whole life premiums are a lot higher than term life insurance products.
If you compare average life insurance rates, you can easily see the difference. For example, $500,000 of whole life coverage for a 30-year-old woman costs around $3,750 annually, on average. That same level of coverage with a 30-year term life policy would cost an average of about $300 annually.
Be wary of thinking about a whole life policy as an investment vehicle — there’s a temptation to see it as both an insurance and an investment product. Many savvy investors can find better options in the world of 401(k)s, individual retirement accounts, stocks or real estate.
Universal life insurance
A universal life policy also provides permanent coverage, but it allows for some flexibility. Universal life policies allow you to make larger or smaller payments, depending on your finances or how the investment account performs. If things go well, you may be able to stop making payments. If they go poorly, you may need to increase the amount you pay to cover the shortfall.
Universal life insurance depends on how the insurance company’s investments perform. If it makes the wrong choices, you may need to pay more than you originally planned.
Other permanent life insurance options
Indexed universal life is a type of universal life insurance, and it puts investments into insurance-company-designed index funds, which try to track the stock market. IUL policies are more complicated than plain universal life policies, often including caps on returns and complex fee structures.
Variable universal life is more flexible and more complex than IUL. It allows policyholders to invest in many other channels to try and increase their returns. However, those investments come with a lot more risk.
Variable life sounds a lot like variable universal life but is actually different. It’s an alternative to whole life with a fixed payout. However, policyholders can use stocks and other investments to grow the cash value of the policy. Both variable universal life and variable life come with increased risk and both are treated as securities — i.e., stocks and bonds — by the government.
How life insurance is priced
One of the most important parts of the price you pay for life insurance is your health. Healthier people are less likely to die soon, which means companies can charge them less money for life insurance. Younger people are also less likely to die soon, so life insurance is cheaper (on average) for younger buyers.
Women live longer, non-smokers live longer, people without complex medical problems live longer, and on and on goes the list. People in these groups will normally get preferential pricing for life insurance.
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Many life insurance applications require a medical exam. They’ll check your weight, blood pressure, cholesterol and other factors to try and determine your overall health.
Some providers will issue life insurance without a detailed medical exam, but you’ll pay more for coverage. You may also be limited to less coverage than you’re hoping for, with some larger insurers maxing out no-exam policies at just $50,000.
If you just need a small amount of coverage, you might be better off checking to see if your employer offers life insurance as a perk. Employee life insurance can often cover the basic end-of-life expenses and may cover some or all of your annual salary. Basic coverage usually doesn’t require any exam and may even be free.