What is Term Life Insurance and How Does It Work?

Term life insurance is almost certainly the most popular type of life insurance policy there is.

This is due to a combination of both low-cost and simplicity.

As a result, it’s not only the most common form of life insurance provided by employers, but many insurance providers offer only term life insurance.

It’s easy to see why.

Term life insurance is so inexpensive and attainable for people who otherwise could not afford coverage. It also affords a higher death benefit than would be possible with other types of life insurance.

But exactly what is term life insurance, how does it work, and what can – or can’t – it do for you?

What is Term Life Insurance?

Term life insurance is exactly what the name implies – it’s a life insurance policy that exists for a specific amount of time.

For example, a typical term life insurance policy will be in force for anywhere from five years to 30.

In most cases, both the coverage and the premium payments will remain fixed for the entire stated length of the term.

Once the policy is in force, it cannot be canceled for any reason except for nonpayment of premiums.

But apart from limited terms, what most separates term life insurance from other types of life insurance is the absence of non-insurance features.

Term life insurance is sometimes referred to as pure life insurance because the life insurance death benefit is generally all it offers.

This absence of special features makes term life insurance so much less expensive than other policy types.

However, that doesn’t mean term life insurance policies are completely inflexible.

There are different types of term life insurance policies, as well as certain riders that can be added to the policy that will make it possible to customize your plan.

For example, adding an accelerated death benefit rider to your term policy will allow you to access some of your death benefits to pay medical or living expenses if you contract a terminal illness.

How Does Term Life Insurance Work?

As discussed above, when you purchase a term life insurance policy, you’ll be buying a fixed amount of death benefit for a fixed annual premium.

In the vast majority of term life insurance policies, the premium will not increase during the original term of the policy.

Your premium will be based on your age and health condition at the time you buy the policy.

Naturally, the lowest premiums are available for those who are younger and in excellent health.

Application Process

When you apply, you’ll generally be asked to provide answers to a series of health-related questions.

Those will include questions such as:

• current health conditions
• previous health conditions
• your family’s health history
• are you a smoker
• do you consume alcohol
• do you use recreational drugs

The application will request employment information, which can reveal if you work in an occupation considered to be hazardous.

There is only a handful that is, such as lumberjacks, fishermen, and private pilots.

But if you are, you’ll likely be charged a higher premium to adjust for the additional risk.

It’s important to answer all questions honestly.

Life insurance companies don’t rely solely on the information you provide on the application.

They’ll cross-reference that against third-party databases, like the MIB, which acts as something like a credit repository for health records.

It’s likely they’ll also check your driving history with the state department of motor vehicles and even do a criminal background check.

The purpose of gathering all the information is to make the best assessment of your risk as a customer.

The lower that risk is, the lower your premium will be.

Should you die during the term of the policy, the death benefit paid to your beneficiaries will be income tax-free, as long as the premiums paid for the coverage weren’t deducted as a business expense.

How Much Does Term Life Insurance Cost?

Term life insurance is almost always the least expensive type of life insurance you can buy.

Generally speaking, you can buy term life insurance for about 10% of the premium cost of an equivalent amount of whole life insurance.

That will give you the option to:

• either save money on your life insurance cost
• or use the savings to purchase a larger amount of coverage

For example, let’s say a $200,000 whole life insurance policy will cost $2,500 per year. With a term policy, the same death benefit will have a premium of $250.

You can purchase five times as much life insurance! $1 million – at only 50% of what it will cost for $200,000 in whole life insurance.

Not only will you have a much higher death benefit, but you’ll still be saving a lot of money on the premium.

Factors Affecting Term Life Insurance Rates

Exactly what you’re premium will be with a term policy will depend on a combination of factors.

Those will include:

• your age
• health profile
• other risk factors
• the amount of the death benefit
• length of the term

For example, if you’re a 25-year-old in excellent health, you’ll be likely to pay something like $30 per month for a $500,000 death benefit on a 20-year term life insurance policy.

By age 50, the same policy is likely to cost somewhere between $120 and $150 per month.

Be aware that if you’re a smoker, your monthly premium will be two to three times as high as it will be for a non-smoker.

You should also know that this type of coverage is cheaper on a per thousand basis with higher death benefits.

For example, the premium on a $1 million, 20-year term policy might be $55 per month, compared to $30 per month for $500,000 policy.

Different Types of Term Life Insurance

Even though term life insurance is the simplest type of life insurance policy, there are variations.

Level Term

The most common type is level term.

This is a policy with a term ranging from five years to 30 years.

During that time, both the death benefit and the premium cost will be fixed.

Yearly Renewable Term

There are also shorter-term policies, like yearly renewable term policies.

You might sign up for such a policy because it’s less expensive than level term, or at least it is in the early years.

But the policy will be subject to renewal on an annual basis.

You won’t need to qualify based on the condition of your health. However, the premium will be adjusted based on your age.

That means the premium will increase each and every year the policy is in force.

Many level term policies automatically convert to yearly renewable term policies.

For example, a policy that starts with a 20-year level term may give you the option to renew annually for a certain number of years.

The premium you’ll pay will be much higher, though, since you’re 20 years older at the time.

But you may be able to offset the higher premium by reducing the death benefit.

Decreasing Term

The third type of term life insurance is decreasing term policies.

They’re specifically set up with a gradually decreasing death benefit in recognition of the fact that your need for life insurance will decrease over time.

Decreasing term policies are primarily used in connection with debt.

One particularly popular debt they’re used in connection with our mortgages.

Since the outstanding balance of a mortgage loan decreases over time, a decreasing term policy will lower the death benefit to parallel the steadily declining mortgage balance.

The complication with decreasing term policies is that while the death benefit declines, the premium remains fixed throughout the term.

They may be cheaper than level term policies in the early years, but as the death benefit declines, the premium cost rises in relation to the death benefit.

Term Life Insurance vs. Whole Life Insurance

There are several features that distinguish term life insurance from whole life insurance.

Here are those features, some of which we’ve already discussed:

Duration

While a term life insurance policy is in force for a specific amount of time, whole life insurance is permanent coverage.

Term will either expire entirely at the end of the stated term or convert to a yearly renewal policy with increased premiums.

But whole life insurance will remain fixed with both the premium and death benefit.

You can literally have the policy in force for your entire life, as long as you make the premium payments each year.

Cash Value

Whole life insurance has a cash value accumulation provision. This is the primary reason why it costs so much more than term.

A percentage of your premium will be allocated to the cash value each year.

This will happen on a sliding scale, with only a small percentage of the premium paid into the cash value in the early years but a larger percentage later on.

Not only does the cash value build over time, but it also pays interest.

You’ll be able to borrow against the cash value in the policy at very favorable interest rates.

However, you can also receive the cash value if you terminate the policy. And if you keep the cash value in the policy, it will be paid to your beneficiaries in addition to the policy death benefit.

By contrast, term life insurance policies do not offer a cash value provision.

Cost

As previously discussed, whole life insurance premiums are roughly 10 times higher than those for term life insurance for the same death benefit.

Though the primary difference between the two is the cash value provision in the whole life policy, there are also fees.

Whole life insurance policies have a series of administrative fees and commissions, particularly in the policy’s early years.

Term life insurance, by contrast, is very light on fees. This helps to keep the premiums low.

The Benefits of Term Life Insurance

Affordability

Low cost is the primary benefit of term life insurance.

Since it’s so much less expensive than whole life insurance, many more people can purchase coverage.

And because it’s so much less expensive, you can buy a lot more coverage and still save money.

This is especially important for young families, who typically have a combination of high life insurance need with serious budgetary constraints.

Term life insurance may be the only option for a family to purchase affordable coverage.

The low cost of coverage means it can be purchased for each member of the household, including the children.

Simplicity

Another benefit is simplicity. Whole life insurance policies and investment-type life insurance policies are often a complex web of provisions and fees.

That can make it difficult for non-insurance folks to understand.

Term life insurance, on the other hand, is the least complicated policy type.

You pay a fixed premium for a predetermined number of years for a flat death benefit amount.

Flexibility

Finally, there’s flexibility. Precisely because term life insurance is so inexpensive and has limited terms, you can adjust your coverage amounts based on your need at the time.

For example, you may choose to have a $1 million policy in force while you have young children.

Once your children are emancipated, you may find you only need a policy for $200,000.

You can make that adjustment with term life insurance in a way you can’t with other life insurance plans.

The Drawback of Term Life Insurance

Temporary

The major disadvantage here is that it’s temporary.

If the policy has a guaranteed renewability provision, you’ll be able to extend coverage beyond the original term.

Guaranteed renewability means you’ll be able to renew the policy – usually to a yearly term policy – without regard for a change in your health condition.

However, you will still pay a higher premium based on your age at the time of renewal.

If your policy doesn’t have a guaranteed renewability provision, it’s possible the insurance company could terminate your policy at the end of the term.

This will be even more likely if your health has deteriorated since taking the original policy.

But even with the guaranteed renewability provision, you may find the cost of renewing coverage to be prohibitive.

If the renewal provision is based on a yearly term, it will just be a question of time before the premium will become a problem.

Either high premium cost or no provision for renewability could leave you in a position of having no life insurance coverage.

Is a Term Life Insurance Policy Best For You?

Despite any disadvantages associated with term life insurance, it’s the best life insurance option for the largest number of people.

This is true not only because of its low cost but also because that low cost enables you to buy more coverage.

Whole life insurance usually makes sense only for those who anticipate developing a serious health condition later in life.

Whole life insurance coverage would eliminate the need to shop for another policy when that happens.

It’s also often argued that whole life insurance is the better choice for people who can’t save money.

Because of the cash value accumulation feature, whole life offers both savings and life insurance in the same plan.

But whole life insurance is actually a poor way to save money.

Returns on your cash value are well below what are available through common investments, like index funds.

In addition, your returns on the cash value of a whole life policy are seriously reduced by fees.

Considering all the above, your first choice for buying life insurance should be term life insurance.