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Term life, whole life, variable life—the sheer variety of life insurance options out there can make your head spin. How do you know what type of life insurance is best for you? What kind of life insurance policy you need depends on factors such as how long you want the policy to last, how much you want to pay, and what you envision for your family's future. Understanding the basic types of life insurance policies will help you select the right one for your situation.
How Do Life Insurance Policies Work?
As with home or auto insurance, you purchase a certain amount of life insurance coverage and pay annual premiums for it. If you die while insured, your beneficiaries will receive a payout of the amount of coverage you purchased; this is called the death benefit.
Do you need life insurance? If you provide financially for your dependents, the answer is yes—especially if you're the sole wage earner. Stay-at-home parents should also consider life insurance to cover the cost of replacing services they provide for free, such as child care and housekeeping.
On the other hand, if you're single, don't have any dependents and have enough money to pay your debts when you die, you really don't need life insurance. Of course, you can still purchase life insurance if you want and declare a favorite relative, charity or whomever you choose as the beneficiary.
What Is Term Life Insurance?
Life insurance falls into two basic categories: term life and permanent life. Term life insurance remains in force for a specific term, usually ranging from one to 30 years. If you die within that term, the policy pays a death benefit. In most cases, you'll pay the same premium throughout the term.
Term insurance is often purchased to protect a family through a specific period. For instance, the parents of young children might buy a 20-year term life insurance policy to provide for the cost of raising the children if one parent dies. But what if your term is up and you still want life insurance? You have a couple of options.
You can buy a new policy; however, this generally requires undergoing a medical exam, which might uncover issues that will make insurers less willing to cover you. Even if you pass the exam or otherwise provide what's called "evidence of insurability," premiums typically get more expensive as you get older, regardless of your health.
You can avoid the need for a medical exam by getting a term life policy that has a renewal guarantee. This guarantees you can start a new term when the current term is up without getting a medical exam or otherwise documenting your health. Your premiums will still go up due to your age, but if you've developed a health problem—for example, you had a triple bypass right before the original term life policy ended—the life insurance company will still have to insure you.
Because term life insurance generally costs less than permanent life insurance for the same amount of coverage, it can be a good choice for families on a budget. You can also get convertible term life insurance policies; these can be converted into permanent life insurance policy with cash value.
What Is Whole Life Insurance?
There are several types of permanent life insurance, of which whole life insurance is the most common. Permanent life insurance differs from term life in two significant ways: It lasts as long as you live, and it has a cash value in addition to the death benefit (or face value). The cash value of a permanent life insurance policy grows tax-deferred over time. Once the cash value reaches a certain point, you have several options for using it.
- You can borrow against it without the need for a credit check, although any unpaid loan balance will reduce your death benefit. You can also use it to pay the premiums, eliminating any out-of-pocket spending on life insurance.
- You can withdraw some or all of it. The cash value of your permanent life insurance can be a source of income, and unlike most retirement savings vehicles, you can access it at any age. Withdrawing cash value will lower the amount of your death benefit; withdrawing all of it (called surrendering the policy) will cancel your insurance.
- You can trade it in to increase your death benefit. When you die, the cash value of permanent life insurance goes to the insurance company, not to your beneficiary. If you want that money to go to your heirs, you can usually exchange it for an equivalent increase in the death benefit.
Permanent life insurance is significantly more expensive than term life insurance, and you risk losing the cash value if you don't access it before you die. For those who are maxing out other retirement investment vehicles, though, it can offer another way to grow their wealth and leave money to their heirs.
Whole life insurance is the most conservative permanent life insurance option for those seeking both insurance and investment growth. The premium stays the same no matter how old you are, and the death benefit is guaranteed. The cash value comes from dividends paid by the insurer and is guaranteed to increase every year. However, you don't have a lot of flexibility with a whole life plan: You can't choose what you invest in or change the policy coverage once you've set up the plan.
Universal life insurance, another type of permanent life insurance, offers a bit more flexibility. Cash value growth is guaranteed, but you may be able to modify your coverage or premiums.
If you're more comfortable with risk, you may be interested in variable life insurance. This type of permanent life insurance lets you choose where to invest your cash value—for example, in stocks, bonds or money market accounts—giving you the potential for greater returns. The tradeoff: Your cash value is not guaranteed.
Finally, variable universal life insurance combines aspects of universal and variable life insurance. You can select your investments, adjust your coverage and may be able to modify your premium payments. As you might expect, this is a riskier investment, with no guarantee your cash value will increase.
Other Forms of Life Insurance
Joint life insurance is a less common form of life insurance that many people aren't aware of. A joint life insurance policy covers two people (usually spouses) and can be either term or permanent life insurance. There are two types of joint life insurance: first-to-die and survivorship.
A first-to-die life insurance policy pays a death benefit to the surviving spouse when the first one dies. At that point, the policy is no longer in force. If the surviving spouse wants life insurance, they have to buy a new insurance policy.
Why would you buy a joint first-to-die policy? In some cases, getting a joint policy can be cheaper than getting two separate life insurance policies. However, if one spouse is in poor health, the high cost to insure them could drive up the overall premiums. By purchasing a joint policy, you also lose the ability to tailor coverage for each spouse.
A survivorship life insurance policy (sometimes called second-to-die) does not pay out until both spouses die. When the first spouse dies, the survivor must keep paying the insurance premiums to keep the policy in force. When the second spouse dies, the heirs receive the death benefit.
Because there is no payout when the first spouse dies, survivorship policies are not meant to provide income replacement for the surviving spouse. Instead, they're typically used by high-net-worth couples to ensure their heirs receive an inheritance or have enough money to pay estate taxes.
When buying any type of joint life insurance policy, be sure to find out what happens to the policy if you divorce.
Can You Have More Than One Life Insurance Policy?
Many people have more than one life insurance policy. Common situations where multiple policies make sense include:
- Your employer offers life insurance. Many people receive life insurance at little or no cost as an employee benefit. Since employer-provided life insurance coverage ends when your employment does, you shouldn't rely on it as your sole form of life insurance.
- It's cheaper than increasing the coverage on your current policy. If you buy a house with a bigger mortgage, get a massive raise or have another child, you might want more life insurance. Buying additional policies sometimes costs less than increasing the death benefit on your existing policy.
- You want to use the "ladder strategy." This is a financial planning tactic where you buy different amounts of term life insurance for different life stages. For instance, a young family with a 30-year mortgage could take out a 30-year term life insurance policy that covers the amount of the mortgage and a 20-year term life insurance policy to cover child-rearing costs. Laddering can be complex; a financial advisor can help you decide if this strategy is right for you.
Although there's no law against having multiple life insurance policies, there is a limit to the total amount of coverage you can get. When deciding how much coverage to offer you, insurers consider several factors, including your existing coverage, income, projected years in the workforce, debts and who would be financially impacted by your death.
Because life insurance is meant to replace your income and cover your debts, the amount you can qualify for is commensurate with your earning power and financial obligations. For example, if you're 30, earn $150,000 a year, are married with six children and have a $500,000 mortgage, you will generally be able to get more life insurance than a single 55-year-old who earns $50,000 a year, has no children and owns their home free and clear.
How to Find the Right Life Insurance Policy
Clearly, life insurance can get complicated. To find the best life insurance policy for your situation:
- Decide how much coverage you need. Add up your debts (such as the outstanding amount of your mortgage and car loans). Then determine how much income you'd need to replace if you die, and for how many years you'd like to replace it. For example, if your spouse is 35, you might want to replace income for 30 years until he or she is 65 and can access Medicare, retirement accounts and other sources of income. Finally, add up your liquid assets (such as savings accounts and investments). Subtract your assets from the debts you owe and the income you need to replace, and you'll have a good estimate of how much insurance to buy.
- Decide on the term and policy that work best for you. How long do you need to cover expenses for your family? If your children are almost grown and will be out of the house soon, you may want a shorter-term policy than if they are toddlers. If you like the idea of cash value and can afford higher premiums, permanent life insurance might be a better option than term life insurance.
- Shop around for the best prices. You can get estimated quotes online or by contacting an insurance agent. An independent insurance broker representing a variety of insurance companies can provide a wide range of products to choose from, helping you consider all your options.
The Best Type of Life Insurance for You
Life insurance can be the foundation of a financially secure future for your family. Choosing the right life insurance can be confusing, however, so you may want to consult an expert. A financial advisor or estate planner can help you determine how life insurance fits into your overall financial plan and identify the best types of insurance to achieve your goals.