What is Term Life Insurance and How Does It Work?

Term life insurance is one of the most affordable ways to protect your loved ones financially if you were to pass away unexpectedly. But how does term life insurance work and is it the right type of policy for your needs? This comprehensive guide will explain everything you need to know about term life insurance.

What is Term Life Insurance?

Term life insurance provides financial protection for a set period of time, usually 10, 15, 20 or 30 years. It pays out a lump sum death benefit to your designated beneficiaries if you die during the term of the policy.

Unlike permanent life insurance such as whole life or universal life, term life insurance does not build up cash value. It purely exists to provide a death benefit payout if you pass away during the term.

The key features of term life insurance include:

• Temporary coverage – It only covers you for a specific term, not your whole life.
• Death benefit – Your beneficiaries get a lump sum payout if you die during the term.
• No cash value – The policy only pays if you die, not if you live.
• Low cost – Premiums are much lower compared to permanent life insurance.
• Guaranteed rates – Your premium is fixed for the length of the initial term.

Term life insurance can provide affordable income replacement if the breadwinner of a family dies unexpectedly. The payout can cover everyday living expenses, mortgage payments, debts, and college tuition costs.

How Does Term Life Insurance Work?

Term life insurance works by providing guaranteed protection for a set period of time. Here’s an overview of how term life typically functions:

• You choose the length of the term, such as 10 or 20 years. This is called the policy term.
• You select the death benefit amount, such as $250,000 or $500,000. This is the payout your beneficiaries would receive if you die during the term.
• You pay a monthly or annual premium to maintain the coverage. Premiums are level and guaranteed not to change over the initial policy term.
• If you die during the term, the death benefit is paid tax-free to your designated beneficiaries. They can use this money however they wish.
• If you live longer than the term length, the policy simply expires unless you renew it. You would not get any payout.

When you apply for term life insurance, the insurance company will assess your life expectancy based on factors like your age, health, family history, occupation, and hobbies.

This determines your risk profile and premium amount. The younger and healthier you are, the lower your premiums will generally be.

Once approved, you’ll pay locked-in premiums for the entire term. As long as you pay your premiums on time, the death benefit is guaranteed.

Explore more about the impact of life circumstances on insurance premiums and benefits in the blog What happens to your debt when you die?

Types of Term Life Insurance Policies

There are several varieties of term life insurance policies available. The most common options include:

Level Term Life Insurance

This is the most basic and popular type of term life insurance. Your death benefit and premiums stay exactly the same throughout the entire term length. Level premium term life is easy to understand and budget for.

Annually Renewable Term Life

With annually renewable term (ART), your premiums increase each year as you age. However, you are guaranteed the ability to renew the policy annually without any medical underwriting. It provides flexibility but premiums get more expensive over time.

Decreasing Term Life Insurance

As the name suggests, the death benefit decreases incrementally over the term length with this type of policy. However, premiums remain level. Decreasing term insurance is sometimes used to cover a mortgage, with the death benefit matching the declining loan balance.

Return of Premium Term Life

Some term life policies will return all or part of the premiums you paid over the term if you outlive the policy. However, expect much higher monthly premiums for this benefit. It is an expensive option.

Determining the Right Term Length

One of the big decisions with term life insurance is choosing the duration of the term. Here are some guidelines on determining the right term length:

• Short term (10 years): Covers temporary needs like supplementing another policy, filling a gap in coverage, or providing additional protection near retirement.
• Mid-term (15-20 years): Ideal for covering financial obligations like mortgages, child-rearing years, and college tuition costs.
• Long term (25-30 years): Best for young families who want to cover their working careers and provide lasting financial security for children.

Think about how long you anticipate needing life insurance. Do you want coverage until retirement, until any kids are through college, or to pay off debts? Match the term length to your specific needs.

20-year terms are the most popular choice for many families. But consider laddering multiple term policies if you have needs of different durations.

How Much Term Life Insurance Do You Need?

Choosing the right coverage amount is arguably the most important decision when buying term life insurance. Here are some common ways to calculate your needed term life insurance policy amount:

• Income replacement method: Add up the years of income you want to replace for dependents and total expected expenses. This gives you a lump sum needed.
• Debt coverage method: Total any debts like mortgages, loans, and college costs. Get enough to pay these off.
• Rules of thumb: Multiples of your income like 10x or 20x annual earnings are quick ways to estimate needs.
• Insurance calculators: Use free online insurance calculators to help determine needs based on your unique situation.
• Work with an agent: An independent insurance agent can provide personalized guidance on calculating the optimal term life insurance amount.

It’s usually better to overestimate your coverage needs rather than underestimate them. An insurance agent or financial advisor can help pinpoint the right term life insurance amount.

What Happens at the End of a Term Life Policy?

As you approach the end of your term life insurance policy period, you generally have a few options:

• You can renew the existing policy annually. However, expect much more expensive premiums since you will have aged.
• You may be able to convert the term policy to a permanent life insurance policy like whole life or universal life, depending on your individual policy. Converting avoids new medical underwriting.
• Shop for a new term life policy if your needs for coverage continue. Just be aware your health or age may make getting approved more difficult.
• Let the policy expire if you no longer need life insurance. But be certain your financial obligations that needed coverage have ended.

If you developed health conditions during the term, the option to renew or convert the policy becomes especially valuable, since getting covered with new individual life insurance may be challenging.

Pros and Cons of Term Life Insurance

Here are some of the key advantages and potential drawbacks of term life insurance:

Pros

• Low cost compared to permanent insurance
• Ability to get large death benefit amounts affordably
• Guaranteed level premiums during term period
• Coverage can be customized for your exact needs
• Still eligible for coverage if health declines later

Cons

• No cash value accumulation like whole life insurance
• Chance of paying premiums yet getting no payout
• Risk of being unable to renew after term expires
• Usually limited conversion options to permanent coverage

Overall, term life insurance provides very economical coverage for temporary needs like protecting dependents or covering debts. Just be sure to choose a term length and amount carefully aligned with your goals.

Term Life Insurance FAQs

Does a term life insurance payout get taxed?

No, term life insurance death benefit payouts to beneficiaries are generally not taxed as income. The value does get factored into your estate for estate tax purposes if your estate exceeds limits.

Can you borrow against a term life insurance policy?

No, term life insurance policies do not build cash value, so they do not allow policy loans or withdrawals. Only permanent life insurance policies allow this.

Is term life insurance refundable if you don’t die?

With most term life policies, you do not get premium refunds if you outlive the term. However, return of premium term life will refund some or all premiums at the end of the term.

Can you renew term life insurance?

Most term life insurance is guaranteed renewable, meaning you can re-apply to continue coverage at the end of the term. But expect much higher premiums based on your attained age at renewal.

Is term life insurance worth it?

For most families with temporary coverage needs, term life insurance is very worthwhile because premiums are so affordable compared to permanent insurance. It can pay for final expenses, debts, and income replacement if you pass away during the term.

The Bottom Line

Term life insurance can be an economical way to secure financial safety and income replacement for your loved ones over a set time horizon. The key is choosing an affordable term length and death benefit amount that provides enough protection for your family’s financial needs if you were to pass away unexpectedly. Term life insurance is often the most economical way to achieve this.