Many people who understand what life insurance is and how it works consider it the foundation of a sound financial plan. And no one likes to think about passing on, especially when we are young and healthy. But imagine if something bad was to happen to you tomorrow. What financial situation do you think your spouse, children, or business will end up in? Life insurance 101 can help you protect your loved ones and the people who depend on you financially, in the event of your passing. Your beneficiaries can use the insurance policy to cover funeral expenses, college tuition, mortgage, estate taxes and other expenses that can ease financial difficulties.
Choosing a proper life insurance policy is a big decision. There are many important factors to consider before you find the best insurance solution. Luckily, we bring you this life insurance 101 guide that will help you understand how life insurance works, what types of coverage there are, and how to choose a policy that will work best for you.
What is Life Insurance 101?
Life insurance is a contract with an insurance company. The life insurance company guarantees a lump-sum payment, also known as a death benefit, in exchange for premiums by the policyholder. Upon the death of the insured, their beneficiaries are entitled to the payment that can be used to cover things like mortgages, private student loans, taxes, medical bills, childcare expenses, college expenses, or to just cover everyday expenses.
In plain words, life insurance is a way of helping your family cope financially if you pass away unexpectedly. According to statistics, only 61% of adult American men and 57% of adult American women have some form of life insurance coverage.
Advantages and Disadvantages
Like health insurance, owning life insurance comes with both pros and cons. The advantages include:
- It is more affordable than you think it is.
- It can be easily purchased, even online.
- Insurance policies are flexible to your needs.
- It is tax-free, so you don’t have to worry about tax code changes.
- It is a great financial back-up plan for your family, giving you extra peace of mind.
Unfortunately, signing up with a life insurance company also has a few disadvantages which you need to take into consideration. Some of them include:
- It costs money, as you have to make premium payments.
- The life insurance acquisition process can be annoying and confusing.
- You have to think about death, whether you like it or not.
- It brings your financial responsibilities in focus (some individuals can find it daunting to accept that a great number of people depend on them).
Answering these questions is not as easy as it sounds. Most people do not know what the appropriate life insurance policy amount should be. This life insurance 101 guide will help you consider all the important factors, so you can find the solution that will best work for you. The amount your life insurance policy should depend on your financial situation, your family structure, future plans, current lifestyle, and the expenses you want your family to be able to cover, in case of your passing.
Let’s say you want to cover your end-of-life and funeral expenses. You might want to consider a small term policy with $10,000 to $20,000 worth of insurance coverage. This policy is ideal if your kids have moved out of the house and your spouse is working. If, on the other hand, your stay-at-home partner and young children rely on your salary and you have substantial debt, you would want to choose a larger life insurance policy, with the amount ranging from $500,000 to $2 million, or more. Now that you are close to answering the question on the amount of policy you should buy, it is recommended that you get one that is 10x your annual salary.
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How Much Does Life Insurance Cost?
The perceived risk of you dying within each premium year is what determines your life insurance cost. This is the age factor. You will pay a higher premium the older you are and the poorer your health is. Additionally, the type of policy and the amount of the sum insured also dictate the cost. And finally, your occupation, hobbies, lifestyle and even your zip code play an important role in the amount of the insurance cost. Therefore, a healthy 25-year-old who does not have a dangerous job and exercises regularly might pay $20 per month towards a $100,000 policy, while a middle-aged man in average health might need to foot $50 per month towards a $100,000 policy.
How to Buy Life Insurance
There are a few key things to know about purchasing life insurance. If you are considering life insurance, it’s probably become clear that an insurance policy is only as good as the company that provides it. Therefore, you have to choose an A+ rated insurance company on which you can rely to be around for as long as you will need your coverage. You are looking for a company and an insurance agent that has knowledge and experience in investing premiums prudently so that they can pay the benefits. Also, shop around to make sure you are getting the best rate.
Additionally, did you know that you can buy insurance through your employer? Since it is usually a group life insurance policy, you might not be able to choose a provider but you can choose the term and coverage. If you need help regarding your finances, insurance, and other related issues, make sure you consult a financial professional.
Main Types of Life Insurance
There are two basic types of life insurance: term and permanent. Term insurance is also known as temporary insurance, and it lasts for a set time period (usually up to 30 years) or until a certain age. On the other hand, permanent insurance, also known as whole life insurance, lasts your entire life, or usually to the age of 100 years.
This insurance provides coverage for a certain period of time, and in case the insured dies during the time period specified in the policy, the insurance company pays a death benefit, which is often tax-free. Most term life insurance policies offer guaranteed level premiums, which means that your monthly rate will not change over the years. For example, if your monthly premium is $25 when you sign up, it will still be $25 next month, next year, and until the end of the term.
Why do you need term life insurance?
People purchase term insurance because they want coverage during specific years when they may need it the most. For example, you and your spouse have just bought your first home and you want coverage that lasts until your mortgage is fully paid off. Or, if you have kids, you might go with a term length that lasts until you finish paying for their college tuition. In an ideal world, your need for insurance will end around the time the term expires; your kids will finish college, you will have paid off your mortgage, and you will have plenty of money in savings.
When purchasing a term policy, a beneficiary should keep in mind these key points:
- Go with a term that goes along with the years you will be paying the bills.
- Purchase an amount that people in your life who are financially dependent on you would need if you were no longer there to provide for them.
- If you find out that the amount is not enough, you would need to buy an additional policy for extra coverage, because you cannot change the amount of coverage within an existing term policy.
- Term insurance costs more as you get older (because of life expectancy).
- Choose a suitable term length early in life because, if you outlive your policy term, you will have to buy another policy, which can be costly as your health condition and older age will be taken into consideration.
Different Types of Term Life Insurance Policies
Before you choose a suitable policy, you should consider the facts about each type of term life insurance, which we cover below.
- Guaranteed Level Premium – This is the most common type of term insurance that usually lasts for 10, 20 or 30 years. Your premium stays the same during the policy’s time period. With it, you can renew your coverage at the end of the term thanks to renewal clauses, although the ability to renew it is not guaranteed. Premiums will rise each year after the level term period.
- Annual Renewable Term (ART) – This is a short term life insurance policy that gives you coverage for one year, and can be renewed on an annual basis for a defined length of time, without taking another medical exam. Every time you renew the life policy, premiums go up. One of the reasons for this is because the premium is determined based on your risk of dying within the current year. Additionally, when it comes to the premium charged, ART is the least expensive form of life insurance.
- Return of Premium – You should consider this type of insurance if you would like insurance that guarantees to refund all your life insurance premiums when the term period ends. The only condition is that you outlive the policy, meaning no death benefit has been paid by the end of the term and all scheduled premiums have been paid out.
- Life Expense – If you want a small policy just to pay for your funeral and other related expenses, such as a headstone, burial, flowers, and memorial service, then you should consider final expense insurance. This policy is often called burial insurance. It is typically purchased by individuals between the ages of 50 and 85 – although some insurance companies will sell policies to people who are older. This coverage pays a lower benefit but the premium cost is usually not high.
- Increasing and Decreasing Term – This insurance is designed to cover a lower claim as the policy ages. While the death benefit decreases over time, the premium usually remains the same. When you hear it for the first time, it might sound odd but this type of insurance is designed for people who have greater financial responsibilities that will decrease over time, such as a mortgage. On the other hand, the death policy can increase over time. If you have young children, you should consider this policy because your coverage needs an increase.
- Guaranteed Issue Insurance – As the name suggests, a guaranteed issue life insurance policy is guaranteed and it provides coverage for anyone who applies for it, regardless of their health concerns. In exchange, you pay a much higher premium because the insurance company takes on more risk by insuring people without knowing much about their current or past health condition. This policy is typically for people over the age of 50.
What happens when your term ends?
After the expiration of your term period, if you think that you still need some type of life insurance protection, you have three options:
- Renewing the coverage
As the policy owner, if you have a term life insurance policy and you reach the age of 95, technically your policy does not expire. By paying your premiums, you keep your existing policy in force. The advantage of extending is that it is worthwhile if you need the coverage for a couple of years. The downside is that premiums will significantly increase and will continue to increase each year as you age.
Most term policies issued in the past ten years have a conversion option, which means that you can convert your term policy to a permanent life policy, for a certain period or up until a specific age. The biggest benefit of conversion is that you do not have to reapply or to undergo a medical examination. However, the downside is that you may not necessarily get the best available policy and your new permanent policy will be more expensive than the term policy you had.
Some policies are renewable, which means that you can extend your coverage for another term, up to a specified age. Renewing is the cheapest option, but you have to prove you are still in good health to qualify for a low rate.
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If you’re looking for insurance that will last for the rest of your life and that has a cash value component, then you need a permanent life policy. This insurance is usually more expensive, but it is perfect for those who need insurance protection no matter when they die or want to leave money for inheritors. Other benefits of permanent insurance include:
- It doesn’t have an expiry date – The policy will pay a death benefit, as long as you pay your premiums.
- It builds cash value – A portion of the premium pays for the cost of the coverage and any remaining amount accumulates cash value, which keeps growing regardless of the market’s ups and downs.
- You can use the cash value in your lifetime – and still, provide a benefit when you die.
- It has tax benefits – The death benefit is typically tax-free, and the cash value grows tax-free over your lifetime.
Permanent life insurance offers different policies you can choose from, according to your needs. Here you have four main options:
- Whole life insurance – This insurance is the oldest form of permanent life insurance. You pay a fixed monthly or annual premium and get a fixed death benefit. This insurance also has a cash value component that slowly accumulates and can be used during your lifetime. You can borrow against your cash value. If you do not pay it back, it will be deducted from your death benefit. Insurance companies typically cover premiums to the age of 100.
- Universal life insurance – This type of insurance allows flexibility with both your premiums and death benefit, giving you options if your economic situation has suddenly changed. You can skip some payments if you have to, making sure to maintain a minimum level of premium payment over the year. These policies accumulate cash value you can access.
- Variable life insurance – Here you have an opportunity to combine death protection with a savings account managed by the insurance company. You can invest it in bonds, stocks, and money market mutual funds. The value of your policy may grow more quickly, but there is also is more risk. If your investments do not perform well, your cash value and death benefit may decrease. Some policies, however, guarantee that your death benefit will not fall below a minimum level.
- Variable universal life insurance – This policy combines features of variable life and universal life policies. There are investment risks and rewards, but you also have flexibility regarding your premiums and death benefit.
Now that we have learned something about life insurance in this life insurance 101 guide, let us ask you this:
Do you have any form of life insurance? What kind of coverage do you have?
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