When it comes to life insurance, most buyers are looking for the right amount of death benefit, the best company to buy it from, the most honest agent to work with, and the least expensive option.
Jump ahead to these sections:
- Definition of Term Life Insurance
- What’s the Difference Between Term Life Insurance and Other Types of Life Insurance?
- Who Typically Buys Term Life Insurance?
- How Much Does Term Life Insurance Cost?
- What Are the Pros and Cons of Term Life Insurance?
- Are There Any Good Alternatives to Term Life Insurance?
That’s exactly why life insurance companies created term life insurance and why they sell more of it than any other type of policy. It meets the life insurance buyer’s objective of owning a higher death benefit than other products at the lowest price point possible.
In this article, we’ll look at the nuts and bolts of term life insurance: what it is, how it’s different from other types of life insurance, its strengths and weaknesses, and more. We’ll also address the matter of how much life insurance you need.
Definition of Term Life Insurance
Term life insurance is a contract between a policy owner and an insurance company. The owner agrees to make premium payments for a specified term (1,10, 20, 30 years); the insurance company agrees to pay a set amount of money (death benefit) to the policy owner's beneficiaries upon the death of the insured (who can be someone other than the policy owner).
The keyword in the name "term insurance" is the word "term." Unlike other types of permanent life insurance (to be discussed in a moment) that stay in force your entire life as long as premiums are paid, term life can expire and never pay a death benefit to a beneficiary.
For example, if you buy a 10-year term life policy and die during that ten years, the insurer will pay a death benefit to your beneficiary. However, when the clock strikes midnight at the end of the 10-year term, you are no longer covered, and the insurance company won't pay out a dollar in benefits to your beneficiaries.
What’s the Difference Between Term Life Insurance and Other Types of Life Insurance?
There are two types of life insurance: term life and permanent life. Within each category, you’ll find different sub-types. Some sub-types of term insurance are annual renewable term, fixed period term (i.e., 10, 20, 30 years), decreasing term life, and return of premium term life insurance.
Some sub-types of permanent life include whole life insurance, universal life insurance, variable universal life insurance, and second-to-die life insurance.
The primary difference between term life and permanent life is that with term life, you pay a premium for a set term of time that will expire if you outlive the term. Furthermore, the insurance company will only pay a death benefit to your beneficiaries if you die during the term period.
With permanent life insurance, you can pay premiums for your entire life; the only way it’s going to expire is if you don’t pay your premiums on time and the policy lapses. Of course, if you die and your premiums are current, your beneficiaries will receive a death benefit.
The other significant difference between term and permanent life is that permanent life accumulates something called “cash value.” Cash value is a policy component that acts much like a savings/investment account. A portion of each premium dollar you pay goes into the cash value account, where its growth will compound over time. Term life does not build any cash value – it’s pure life insurance.
Let’s look at a couple of types of permanent life insurance and compare them with term insurance.
Whole life insurance
Whole life insurance is the “grandaddy of permanent life insurance.” It derives its name, “whole life,” from the fact that as long as you pay your premiums, you can keep it your whole life, and someday, someone you named as a beneficiary is going to get a payout when you die.
Whole life was the first type of life insurance to accumulate cash value. When a portion of your premium payment goes into the cash value component, it is credited with interest and grows over time. The life insurance company also has the option of paying a dividend to its policyholders, which they can add to your cash value.
It’s important to note that the premiums you pay for your whole life policy never increase, no matter how old you get as the policy owner. However, some term policies will increase premiums every year on the policy anniversary date.
There is a big difference in cost between whole life insurance and term life insurance. Premiums for both types of insurance are dependent upon many variables like age, gender, health history, smoker vs. non-smoker, and more. But all things being equal, whole life insurance can be as much as ten times higher in cost than term life insurance.
For example, a 35-year-old female could pay $50 per month for a $300,000 death benefit policy, but she would have to pay $175 per month for a whole life policy with an identical death benefit.
Here’s a chart comparing the policy features of term life and whole life (chart courtesy of Guardian Life).
|
Policy feature |
Term life insurance |
Whole life insurance |
|
Initial cost |
Typically, lower than whole life |
Generally, 6–10x more expensive than term for the same death benefit, but as cash value builds, it can be used to supplement premiums. |
|
Cost over time |
Renewal cost increases with age |
The cost stays the same for life |
|
Permanent coverage |
No |
Yes |
|
Length of coverage |
Typically, 10 – 30 years |
Lifetime coverage (as long as payments are made) |
|
Premium |
Can be level or increase over the length of the policy |
Level – stays the same every month |
|
Health exam required |
In most cases |
In most cases |
|
Cost can decrease over time |
No |
Yes – cost can be offset as cash value builds (typically after 12+ years) |
|
Cash value |
No |
Yes – accumulates over time |
|
Ability to withdraw cash value during life of the policy |
No |
Yes – withdrawals and loans are allowed (but if unrepaid, this will diminish the policy values and death benefit) |
|
Guaranteed death benefit |
Yes |
Yes |
|
Policy structure and provisions |
Relatively simple |
More complex |
Universal life insurance
Another type of permanent insurance we can compare to term life is universal life insurance.
Universal life insurance acts much the same as whole life insurance in that a portion of your premium is allocated to your cash value but differs in the respect that universal life has “flexible premiums.” This means that as your cash value grows, you can pay less each month for your death benefit because the cash value can be used to make premium payments.
Term life insurance doesn’t offer flexible premiums because there is no cash value account to draw from and pay your premium.
Who Typically Buys Term Life Insurance?
Because it’s the most commonly sold type of life insurance, many different types of people with different circumstances buy term life. Here are some examples:
Someone who needs a large face amount for a low premium
Term premiums, particularly when you’re younger, are much lower than they are for permanent life insurance. This allows someone who needs a large death benefit to get an affordable policy that meets their needs.
For example, let’s say John is 30-years-old, just bought a new home with his wife, and took out a 30-year mortgage for $250,000. John can buy a term life policy with a $250,000 death benefit for under $20 a month if he’s in good health and is a non-smoker.
Conversely, if John wanted to buy a whole life insurance policy with a $250,000 death benefit, he would pay at least $175 per month, about eight times as much as he would for the term life policy.
Someone who only needs life insurance temporarily
Whether a 30-year mortgage or a 60-month car loan, a temporary need most often only requires a temporary solution. For example, if Sally takes out a $23,000 car loan for five years and she’s 26 years old living on a tight budget, she wouldn’t need a whole life policy; a 5-year level term life insurance policy would do nicely.
Someone who doesn’t need cash value
Many people are socking money away every payday and have enough saved in their retirement fund that they don’t need to have any cash value building up for them. All they need and want is a death benefit. Term life insurance is perfect for them. Every dollar the policy owner pays goes towards the cost of the insurance.
How Much Does Term Life Insurance Cost?
While several factors determine term life insurance rates—gender, health history, and smoker status, to name several—age is the primary determinant. Term life insurance rates increase as you grow older because your life expectancy gets shorter, meaning life insurance companies will have to pay out a death benefit sooner than they would for someone younger.
As you can see from the chart below (Courtesy of Value Penguin), monthly premiums are much lower when you’re young compared to when you’re older. For example, there is only a 4% difference in the rates between ages 25 and 30, but it jumps to an 86% difference between ages 60 to 65.
|
Age |
Monthly life insurance cost (nonsmoker) |
Monthly life insurance cost (smoker) |
|
25 |
$31 |
$86 |
|
30 |
$33 |
$92 |
|
35 |
$38 |
$117 |
|
40 |
$50 |
$179 |
|
45 |
$78 |
$277 |
|
50 |
$118 |
$426 |
|
55 |
$190 |
$663 |
|
60 |
$318 |
$1,007 |
|
65 |
$593 |
$1,528 |
You’ll notice that rates are much greater if you smoke. The average premium for a smoker is 218% higher for life insurance policies than for a non-smoker.
What Are the Pros and Cons of Term Life Insurance?
If you’re thinking of buying a term life insurance policy, you need to be aware that it has its pros and cons. Here are some for you to consider before you apply for coverage:
Pros
- Premiums are lower when you’re younger
- Your beneficiaries will receive a larger death benefit payout
- Some term policies can be converted to whole life policies
Cons
- It’s temporary coverage
- You have to re-qualify at the end of the term
- It is difficult to be approved when you apply if you’ve had a significant health issue
- Premiums can increase every time you take out a new term policy
- Your policy accumulates no cash value
Are There Any Good Alternatives to Term Life Insurance?
Life insurance is a unique financial product in that a large amount of money can be created for someone with one payment. For example, if you die the day after you take out a $1 million term life policy for which you made one premium payment of $125, your beneficiaries will receive $1 million.
One alternative to term life insurance is self-funding. Instead of paying premiums to the insurance company, you take that money and deposit it into a bank or money market account for safety of principal. You then make regular deposits into that account to create an “emergency fund” for yourself that will provide your heirs with money when you die.
Another alternative to buying term life insurance is an annuity. With an annuity, you deposit money, either a lump sum or a recurring contribution. It will ultimately compound over time, eventually creating a lifetime income stream for you that will pass to a beneficiary when you die.
Both of these options work best if you start them when you’re younger because you’ll have the magic of compound interest working in your favor over a more extended period.
How About the Best of Both Worlds?
The next time you buy life insurance, you’re going to face the issue of applying for a term policy or a permanent policy. You always have a third option: buy both. Many people combine a term policy with a large face amount and a smaller whole life policy that accumulates cash value.
By having both types of policies, your beneficiaries will receive a large death benefit if you die during the term. If you outlive the term, you’ll have accumulated some cash value that you can borrow or withdraw later in life.