Term life insurance is the cheapest, most appropriate, and best type of life insurance for the vast majority of Americans. Whole life insurance is the other type of life insurance with a cash component that can be used to build wealth in a tax-deferred manner.
I’ve personally got a $1 million, 10-year term life insurance when I didn’t have kids. In retrospect, I should have got a 20-year or 25-year term life insurance policy. That would be long enough to cover my two kids through college. Now, I’m more motivated than ever to pay down mortgage debt and build wealth.
Let’s go through what term life insurance actually is and how it works. I’ll then share with you the best way to get a term life insurance policy to protect your loved ones.
What Is Term Life Insurance?
Term life insurance is life insurance that guarantees payment of a stated death benefit during a specified term. Once the term expires, the policyholder can do one of three things. Renew it for another term, convert the policy to permanent coverage, or allow the policy to terminate.
The most common terms are 10 years, 20 years, and 30 years.
The most common death benefit amounts are $100,000, $250,000, $500,000, $750,000 and $1,000,000. Although you can easily get multiple-million-dollar term life insurance policies if you desire. You’ll just have to pay a higher premium.
The easiest analogy I have for a term life insurance policy is renting an apartment for a specified period of time (term). You pay a monthly rent (premium) to get shelter (life insurance). Once the specified period of time is over, you stop paying rent (premium) and you lose the apartment (life insurance).
How Term Life Insurance Works
The only value a term life insurance policy has is the guaranteed death benefit.
Unlike with a whole life insurance policy, there is no savings component, also know as the cash value.
A term life insurance policy’s purpose is to give insurance to individuals against the loss of life. A whole life insurance policy is to also insure against the loss of life. But while life can also help the policy holder build wealth through a cash value.
Term life insurance is not used for estate planning or charitable-giving purposes. Whereas whole life insurance is commonly used for estate planning purposes.
All premiums from a term life insurance policy cover the cost of underwriting insurance. With whole life insurance, part of the premium goes towards the cost of the death benefit and building up the cash value. Therefore, term life insurance always has a lower premium for a similar death benefit amount.
Features Of Term Life Insurance
Term life insurance premiums are lower than whole life insurance premiums. But, the premium cost still depends on a person’s age, health, and life expectancy. Pricing is determined by the insurer through their actuary database.
The younger and healthier the potential policyholder, the lower the term life insurance premium and vice versa. Therefore, it is often beneficial to get life insurance at a younger age. You can lock in a lower rate for a longer period of time.
If the person should die within the specified policy term, the insurer will pay the face value of the policy. Should the policy expire before the policyholder’s death, there is no payout. Therefore, the “best value” for a policyholder is to die soon after taking out a policy. However, most people would rather live as long as possible.
Upon expiration, policyholders may be able to renew a term policy. But the premiums will most likely go up due to older age and poorer health. Please be aware that age 40 tends to be the age where we see a larger uptick in health insurance premiums due to the onset of more illnesses. Age 40 is when doctors recommend yearly physicals. Age 50 is when doctors recommend colonoscopies.
Term life insurance is cheaper than whole life insurance because it only offers a death benefit instead of a death benefit and a cash value.
For example, a healthy 30-year-old non-smoker can typically obtain a 20-year term life insurance policy with a $300,000 face value for $20 to $30 per month. If the 30-year-old decides to get a $300,000 term life insurance policy at 50-years-old, expect the premium to go up by 3-4X.
Alternatively, a whole life insurance equivalent may cost closer to 10X more given the policyholder is building the cash value.
Finally, because most term life insurance policies expire before paying a death benefit, the overall risk to the insurer is lower than that of a permanent life policy. The reduced risk allows insurers to pass cost savings to the customers in the form of lowering premiums.
Example Of A Term Life Insurance Policy
Let’s use me for example, a 42-year-old, healthy male with two kids. I want to get a $1 million, 10-year term life insurance policy even though my kids are only 1 and 3 because I plan to be completely debt-free in 10 years.
I’ve currently got about $900,000 in mortgage debt. This is why I decided to take out a $1 million death benefit. It’s always a good idea to match the death benefit amount to one’s debt amount.
Because I have enough investment income to pay for our desired lifestyle, I do not need a term that covers my children through college. My investments currently generate about $260,000 a year and we currently spend about $150,000 a year. In other words, we have a large enough buffer before we ever have to touch principal.
The $1 million, 10-year policy costs $100 a month due to my age. It used to cost $40 a month when I was in my mid-30s. If I were to die within 10 years, my wife would receive the $1 million, tax-free death benefit.
I would like her to keep the money for the first three months as she assesses her finances. She can proceed to either pay off all mortgage debt, keep the death benefit as cash, or invest the proceeds.
It’s good to sit on a financial windfall for a while because our minds often rush to do things that might not be the best thing at the moment. For example, my wife may want to simplify her life and sell a rental property. If so, she would lose rental income, but she would pay off the mortgage and turn the real estate equity into cash.
A bad situation is if I were to come down with some terminal illness. If the policy expires before I die, I will not be able to get another life insurance policy. But the positive is, I got to live for more days.
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Term Life Insurance Premiums
Term life insurance premiums is mostly determined by an insured’s age, gender, and health. Other common factors are the insured’s driving record, current medications, smoking status, occupation, hobbies, and family history.
Depending on the policy’s face amount, a medical exam may be required. That amount is usually $1 million or over, although some life insurance carriers require a medical exam for a term policy that is $500,000 or over. It all depends on the insurer’s risk profile.
Term life insurance premiums are the same for the duration of the contracted term. However, upon renewal, your premium will likely increase given your life expectancy has decreased. Therefore, think hard about how long you want the term to be.
Based on actuarial data, the average life expectancy in the U.S. is 79 years. Therefore, a 25-year-old person has a remaining life expectancy of 54 as compared to a 40-year-old with a remaining life expectancy of 39 years. The risk to underwrite insurance for the 25-year-old is less than the risk to cover a 40-year-old person.
If you know you want to get married, have kids, and buy a house with a mortgage, then getting a term life insurance policy that covers that duration is a wise move. By the time you get there, your premiums will likely be higher.
Three Types of Term Life Insurance
There are three types of term life insurance policies. A level term is by far the most common.
1. Level term
These provide coverage for a specified period ranging from 10 to 30 years. Both the death benefit and premium are fixed. These premiums are relatively higher than yearly renewable term policies. However, term life is still much cheaper than whole life.
2. Yearly Renewable Term (YRT) Policies
(YRT) policies have no specified term but are renewable every year without requiring evidence of insurability each year. Premiums start off low, but as the insured ages, premiums increase. Although there is no specified term, premiums can become prohibitively expensive as individuals age, making the policy an unattractive choice for many.
3. Decreasing term policies
These have a death benefit that declines each year according to a predetermined schedule. The policyholder pays a fixed, level premium for the duration of the policy. Decreasing term policies are often used in concert with a mortgage to match the coverage with the declining principal of the home loan.
Because the death benefit declines over time, the premium for a decreasing term policy is generally the lowest premium of all three types of term life insurance policies.
If you want to explore more types of life insurance, this article explains all the various life insurance options available today.
Convertible Term Life Insurance
Before agreeing to your term life insurance policy, I highly recommend inquiring whether the policy has a conversion rider. The conversion rider allows you to convert a term life insurance policy that’s about to expire into a permanent plan without going through underwriting or proving insurability. The conversion rider should allow you to convert to any permanent policy the insurance company offers with no restrictions.
This conversion rider is very important because as we age, bad things tend to happen. For example, I gained some weight and started to snore. I went to see a doctor who said I had sleep apnea and should try a CPAP. Because I saw a doctor, my insurance premiums went up the next time I applied. Please get an insurance policy BEFORE seeing a doctor for any non-life threatening issues.
The conversion rider protects your original health rating upon the term policy conversion, even if you later have health issues or become uninsurable.
Of course, overall premiums will increase significantly, since whole life insurance is paying for the cash benefit as well. The advantage is guaranteed approval without a medical exam.
Key Points For Term Life Insurance
Term life insurance is the cheapest option because it simply guarantees payment of a stated death benefit to the insured’s beneficiaries. There is no cash value component to the policy.
The younger and healthier you are, the cheaper the premiums. If you are planning to start a family, take on a mortgage to buy a house, and want to take care of your dependents long after you are gone, getting term life insurance is a good idea.
Once you have sufficient financial resources where you can self-insure, you’ll no longer need term life insurance. This time usually occurs after retirement and/or when your mortgage is paid off and your children are independent adults.
The most efficient way to get competitive life insurance quotes is to check online with PolicyGenius, the #1 life insurance marketplace where qualified lenders compete for your business. It’s much easier to apply on PolicyGenius than go to each carrier one-by-one to get a quote. I’ve know the founders for years and they have truly build a fantastic resource for individuals.
About the Author: Sam worked in finance for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.
Sam started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world. You can sign up for his free private newsletter here.