How to Buy Life Insurance

man and woman couple comparing life insurances while seated at a table

Life insurance provides financial stability and relief for your loved ones once you die. But buying life insurance isn't always top-of-mind, perhaps because it forces us to think about what happens to our family after we're gone, and that can be difficult.

If your death would financially impact those who depend on you, protecting them with life insurance can give you peace of mind—and ensure they'll be cared for.

Here's how to buy the life insurance you need.

1. Decide What Type of Life Insurance Fits Your Needs

When you buy life insurance, you make premium payments to your insurance company, which in turn pays a death benefit to your beneficiaries if you pass away during the policy term. Depending on the type of life insurance you purchase, your policy can cover everything from burial costs and final expenses to replacing your income for your family and paying off your mortgage.

There are two main types of life insurance: term life and permanent life. A term life policy covers a set period of time, while permanent life insurance covers you for the remainder of your lifetime. Additionally, there are two kinds of permanent coverage: whole life and universal life. Here's how these various forms of life insurance differ:

  • Term life: Term life insurance lasts for a specific period of time, such as 10 or 20 years. According to the Insurance Information Institute, the 20-year term is the most popular term among policyholders. If you pass away during the coverage period, your beneficiaries will receive the death benefit for the amount stated in your policy. Term life insurance policies are popular because they tend to be less expensive than permanent insurance.
  • Whole life: Whole life insurance provides you with lifetime protection, and your payments remain fixed for the life of the policy. In addition to a death benefit, whole life policies include a savings component, or "cash value." The cash value is tax-deferred, meaning you don't pay taxes on the amount you contribute to the policy, and you won't owe taxes on gains until you withdraw it. You can use your policy's cash value to withdraw or borrow money, but doing so will lower the amount paid out to your beneficiaries in the event of your death.
  • Universal life: Like whole life insurance, universal life provides lifetime coverage, but it also allows for some flexibility. It provides a cash value account that earns interest at the market rate. If the account performs well, you may have the option to lower your premium payment or even stop making payments, as long as the account has enough funds to cover the costs. On the other hand, if the interest you receive declines, you may need to increase the amount you pay to cover the shortfall. Universal life insurance policies generally come with guaranteed minimum interest rates, which gives you some protection.

2. Calculate How Much Life Insurance You Need

Once you decide which type of insurance is the best fit for your needs, you'll need to determine the dollar amount of life insurance coverage you need. Financial planners often advise setting your death benefit amount to 10 times your annual income. However, that number could be insufficient to cover your debt, financial obligations and other factors. A death benefit amount of 20 or 30 times your current annual income may be a more realistic formula for some. For example, if your current annual income is $70,000, you might purchase life insurance coverage worth $1.4 million or $2.1 million.

Perhaps a better rule of thumb is to add up your current and future financial obligations, including your current debt, income replacement and future costs, and then subtract all your available liquid assets when you die. Here is a step-by-step breakdown of these important considerations:

  1. Current debt: Add up your current debt obligations, which may include a mortgage, auto loan, credit card balances, student loans, personal loans, health insurance and child care.
  2. Income replacement: Determine how many years your loved ones would need financial support, and multiply your annual salary by that number. Make sure your income replacement is sufficient to cover current and future expenses, plus a little extra to safeguard against inflation.
  3. Future needs: Consider future expenses such as college tuition and weddings for your children, a new car for your spouse and long-term care for an elderly parent. You may want to factor in funeral costs, which are $7,848 on average, according to the National Funeral Directors Association.
  4. Assets: Calculate the sum total of your liquid assets, which are assets you can quickly convert into cash, such as your savings, brokerage accounts, existing college funds and current life insurance.

Subtract the total of your liquid assets from your debt, income replacement and your family's future financial needs. The number you end up with should give you a reasonable estimate of the amount of life insurance you need.

As an example, let's say you have $300,000 in current debt, including your mortgage balance. You also want to include $1.5 million in income replacement and another $200,000 for future financial expenses. All total, your expenses stand at $2 million. If you have $100,000 in liquid assets, the amount of insurance you'll need is $1.9 million ($2 million - $100,000 = $1.9 million).

3. Shop Around for the Best Policy Premiums

It's a wise practice to compare costs for the same policy with different insurance agencies. Most insurers do not include the cost of premiums on their websites, but many offer an online quote generator so you can get an instant quote. If you can't get a quote online, you'll need to contact an agent.

If you're getting quotes for term life insurance, ask the agent if the term length you want is available. You might also ask if you can convert the term coverage to a different kind of policy if your needs change in the future. For example, your income could rise, making the premiums for whole life insurance more affordable. At that time, you may want to switch to a whole life policy and grow your money in a cash value account.

4. Consider Your Time

The application process for life insurance companies can take days or even weeks to complete. You can usually fill out an application online, but to complete the application, you'll still need to hop on a phone call and answer questions about your health history, recreational activities and your finances.

Many insurers require an in-person medical exam, which you can schedule during your phone interview. Typically, the medical exam involves a technician coming to your home and performing blood and urine tests to detect the presence of nicotine and drugs, record your blood pressure and determine your cholesterol and glucose levels.

In some cases, a medical exam is not required, and a telephone interview that details your medical history is all that is needed. But without exam results, the insurance company takes on additional risk. That's why no-exam life insurance policies are often less extensive in coverage and more expensive.

The Bottom Line

If you're buying life insurance, it's essential to obtain a policy that sufficiently protects your loved ones from potentially life-changing financial losses if something happens to you. For example, your life insurance policy can cover final expenses, pay off your mortgage, replace your income and pass down wealth to your heirs.

Remember, you can save money by opting for a term life policy, and good health can keep your rates low. Keep in mind, some states allow insurers to factor your credit when setting premiums using a credit-based insurance score. If you live in one of those states and happen to have great credit, you'll likely pay a lower premium, so it's a good idea to check your credit score and improve your credit if necessary before starting the search for life insurance.