Term life insurance

Thomas Barwick/Getty Images

Purchasing life insurance is a great way to provide financial protection to your loved ones if you were to pass away. Term life insurance can be an attractive option because it offers cost-effective coverage for a specific period of time. Each person’s life insurance needs and financial situation are unique, so the need for coverage varies – much like purchasing home and auto insurance coverage.

There are advantages and disadvantages to purchasing term life insurance, plus different types of coverage available. The ins and outs of term life insurance can be frustrating for those who are not familiar, so it’s important to understand the basics to make the right life insurance choice.

What is term life insurance?

When you purchase term life insurance, you are entering into a contract with a life insurance company for a specific amount of money and period of time, usually 10 to 30 years. If you make the required premium payments, the life insurance company agrees to pay the death benefit amount to a person you designate, as long as you die during that time frame under covered terms.

Advantages of term life insurance Disadvantages of term life insurance
Less expensive than permanent life insurance No savings or investment potential to build wealth
More affordable to purchase a large death benefit amount Only covers a specified time period
Level premiums for term of policy Sunk cost if you outlive the policy

Advantages of term life insurance policies

Term life insurance has a couple of key advantages that make it an attractive option for those who need a larger death benefit. It is typically the cheapest type of life insurance, especially for younger people, making it attractive to young parents. The larger death benefit for a reasonable price can provide for their children if something happens to them.

Many financial planners encourage people to buy term life insurance and invest the money saved by not purchasing more expensive permanent life insurance. Also, for those with level premiums, the cost will not increase with age for the policy’s life as it does with some other types of life insurance.

Disadvantages of term life insurance policies

Term life insurance does have drawbacks, including the fact that it lacks the savings component a whole life insurance policy provides. The only value of the policy to the policyholder’s beneficiaries is the death benefit. While some policyholders use permanent life insurance policies to invest and build wealth, that option does not exist in a term life policy.

Another downside to having a term life insurance policy is that it only covers a policyholder’s beneficiaries for a set period. Because policyholders can outlive their policies, there’s a chance that the coverage will end up as a sunk cost. Furthermore, a study done by Penn State University indicates that 99% of all term policies never pay out a death benefit.

How does term life insurance work?

The only value attached to term life policies is the guaranteed death benefit. Unlike a whole life insurance policy, there is no savings component. The goal of a term life insurance policy is to provide insurance to the policyholder’s beneficiaries against the loss of life in the form of a cash death benefit. Upon the policyholder’s death, beneficiaries can use the cash benefit to settle any outstanding costs that the deceased may have, such as consumer debt, mortgage debt, funeral costs or outstanding healthcare bills.

Since term life insurance does not provide a savings vehicle, policyholders cannot use it to build wealth. Therefore, a term life insurance policy is not used for charitable-giving purposes or estate planning. The premium of a term life insurance plan only covers the cost of underwriting insurance, which typically makes it less expensive than permanent life insurance premiums.

Types of term life insurance

There are several different types of term life insurance, and some offer more guarantees than others. The more guarantees there are, the more expensive the policy. Here is a breakdown of the major types of term life insurance policies:

  • Level term insurance: Both the premiums and the death benefit remain constant over the policy’s life with this form of term coverage. Level term insurance usually lasts for anywhere from 10 to 30 years.
  • Decreasing term insurance: This type of term insurance, usually used to cover a shrinking debt such as a mortgage, is less expensive because the death benefit slowly decreases over time.
  • Guaranteed renewable term insurance: This type of term coverage allows the policyholder to renew the policy at the end of the term without having to undergo a medical exam or prove insurability again. It is more expensive overall, and it is important to note that the policy premiums will still increase with each successive term. A yearly renewable term is a form of guaranteed renewable term coverage.
  • Convertible term insurance: This form of term life insurance can be converted into a smaller amount of paid-up permanent coverage. It is appropriate for those who need more coverage now and also want to have some coverage left when they die.
  • Return-of-premium term insurance: This type of term insurance is one of the most expensive types available, but it offers a money-back guarantee for some or all of the premiums paid if the insured outlives the term. Since statistics show that 99 percent of all term insurance policies never pay a death benefit, this may be a wise investment for those who can afford it.

How much does term life insurance cost?

Term life insurance premiums are calculated based on the age, health and life expectancy of policyholders. Because of this, pricing for a term life insurance policy is highly variable but typically significantly cheaper for a younger user than it would be for someone who is nearing or already in retirement.

The health factors that a term life insurance provider is likely to consider vary from one provider to the next. It is a good idea to shop around and compare rates. A licensed insurance professional can also provide clarity about what role the health of the insured will play in the underwriting decision of a given insurer.

Will I get my money back at the end of my term?

Unless you purchase a return-of-premium term life insurance policy, you will not get any money back at the end of the term. This is one of the potential disadvantages of purchasing term life insurance. Though it is more expensive than the other types of term life insurance, if the premium return component is important to you, it might be worth discussing with a life insurance agent to see if term insurance is the right fit for you and your budget.

Frequently asked questions

What happens to term life insurance at the end of the term?

At the end of a term life insurance policy’s term, policyholders have the option to either renew the policy for a predetermined term of their choosing, convert the policy to a permanent plan or let the plan expire.

While letting the plan expire in most term policies means losing the money paid into premiums, some providers offer “return-of-premium” options that allow people to pay higher premiums in exchange for the option to have all premium payments returned if they outlive their term.

Can I take a life insurance policy out on anyone?

While it is possible to take out a life insurance policy on someone other than yourself, there are some stipulations. There must be a relationship between the person purchasing the policy and the person being insured. The person purchasing the policy must also prove that the death of the insured person would have an adverse effect upon them.