Navigating the landscape of life insurance can be tricky. You're sure to encounter different and confusing policies and phrases, such as whole life, term life, cash value, universal life, and variable life.
But life insurance is important, so it's crucial to understand the types of policies available to you. Learn more about how life insurance works and the types.
- Life insurance policies have a death benefit, which your named beneficiaries can claim when you die.
- The two most common types of policies are term life and permanent life, though there are some other types as well.
- Term life policies provide coverage for a specified period; permanent life insurance offers extended protection.
- Think about your circumstances and what you want a policy to achieve when buying life insurance.
How Does Life Insurance Work?
Life insurance policies have a death benefit. Your named beneficiaries can claim it when you die. You can choose any type of beneficiary you like: your children or spouse, a business partner, or a beloved charity. In many cases, individuals buy life insurance to cover themselves. But you may also consider purchasing a policy to cover your spouse or parent. Or, you can buy it in order to establish a savings vehicle for your child.
Life insurance falls into two categories: Term life policies provide coverage for a specified period. Permanent life insurance offers extended protection. Both types of coverage have advantages and disadvantages; each is tailored to meet the needs of a diverse range of policyholders.
So which type of life insurance policy is best for you? Whether you're in your 20s or 60s, deciding on the right policy type should be a priority. Weighing the details of various policies can help you decide.
Term vs. Permanent Life Insurance
|Term Life Insurance||Permanent Life Insurance|
|Covers you for a set period, so you have the option of paying for coverage only when you think you might need it.||Can provide protection until the date of your death.|
|Premiums may be affordable if you're relatively young and healthy.||The rate is fixed over the life of the policy; you can "lock in" lower premiums if you purchase a policy while you're young.|
|Policies don't accumulate any cash value.||Accumulates value over the years so you can borrow against it or take withdrawals.|
|Renewal may be more difficult, and your rate may increase if your health deteriorates during the term.||Premiums are more expensive than term life policies.|
Term Life Insurance
Term life insurance protects you for a specific period, usually up to 30 years. Typically, the death benefit remains level throughout the life of the policy. This is true even if your health declines during the term. If you purchase a 10-year, $100,000 policy, it will pay a $100,000 death benefit to the beneficiary if you die during the 10-year coverage period.
If you choose a decreasing term policy, the death benefit declines during the life of the policy. This type of policy can provide adequate protection for a mortgage, which decreases with each monthly payment.
Term life policies only pay a death benefit. They don’t build a cash value over time. In most cases, term life policies don’t return any of your money when the term ends. Policies that include a “return of premium” feature will pay back some or all the premiums you paid. But these come with higher rates.
Term life policies often provide the most affordable coverage for young people. That's because rates are based on age and health, and the premium doesn't go toward building a cash value.
You may be able to renew a term life policy at the end of the term. Some policies can be converted to permanent life coverage, which extends coverage until you die. However, most term life policies only offer coverage up to a specified age. Before you buy a term life policy, ask if you’ll lose the ability to renew when you reach a certain age.
Cost and term flexibility are among the advantages of term life insurance. You can use a term life policy to ensure your kids get a college education, your spouse pays off the mortgage, and your family replaces your income if you pass away. Term life policies feature flexible coverage levels. You can choose the death benefit that fits your needs. For instance, let's say you want to cover your $100,000 annual salary for five years. In that case, you might purchase a $500,000 policy.
A term life policy will only cover you up to a specified age. So it won’t provide protection for your heirs if you live well into your golden years.
Permanent Life Insurance
One of the most well-known types of permanent life insurance is whole life insurance. It’s called “whole” life because it covers you until death, regardless of your age at that time. Another common type is universal life insurance. Both types feature a death benefit. It is designed to be paid whenever you die and builds a tax-deferred cash value (that you can potentially access while you've alive).
The cost of insurance rises exponentially with age. This is why permanent policies (which are in force during your later years) are much more expensive than term policies (which aren't).
Permanent life policies can provide an inheritance for your loved ones or a savings plan for you. Once the policy builds a cash value, you can borrow or withdraw funds, which can be used how you please. But if you borrow or withdraw too much money, the policy could potentially lapse leaving your beneficiaries with nothing. For this reason, it's crucial to talk to an insurance professional to understand the impact accessing the cash value can have on your policy.
Whole Life Insurance
Whole life policies come in a couple of general forms, including:
- Nonparticipating whole life insurance: This features a fixed premium and death benefit, along with set cash values stated in the policy.
- Participating whole life insurance: Offered by mutual life insurance companies, participating whole life policies pay dividends. You can receive them as cash, use them to pay future premiums, or increase the death benefit and cash value by buying paid-up additions of life insurance with them.
By law, whole life policies must contain nonforfeiture values. These are paid in cash or another type of insurance if you fail to make payments or decide to drop the coverage.
Universal Life Insurance
Universal life insurance protects you as long as you pay the premium. Like whole life, universal life insurance builds a cash value over time. However, universal life policies apply earnings based on a money market rate of interest. A universal life policy also gives you the option to change your death benefit. Plus, it allows you to adjust your premium payment once the policy accumulates a cash value. This is because, unlike whole life policies, universal life policies are designed to pull your premium from the cash value.
Other Types of Life Insurance
Other types of permanent life policies offer more flexibility, but can increase financial risk. (Technically, these are variations of whole and universal policies).
Variable Life Insurance
This type of permanent life policy also earns a cash value but allows you to invest the cash value in bonds, mutual funds, and/or stocks. If you invest wisely, your cash value may grow quicker than it would with other types of permanent life insurance. However, if your investments don’t perform well, the death benefit and cash value may decrease. This could even cause the policy to lapse. Some variable life policies minimize this risk by guaranteeing your death benefit won’t decrease below a specified level.
Indexed Universal Life Insurance
An indexed universal life insurance policy earns a cash value based on the performance of a market index, like the S&P 500.Indexed universal life policies are subject to caps and floors. These typically guarantee you won't experience a negative return (even if the benchmark index loses value) but also limit the amount of interest credited to your policy. These policies tend to be particularly complex.
Most types of life insurance require you to undergo a medical exam. This is essentially a physical. Insurers use the results of this physical exam to determine your premiums. Being healthier can make a big difference in your cost.
Group Life Insurance
Offered through employers, associations, or professional organizations, group life insurance covers a group of people. A group policy is owned by the entity that purchases it—for instance, an employer—not the individuals it covers. Group policies offer term life coverage, usually with many restrictions. The policyholder can dictate when your coverage will begin. You can make changes to your coverage level.
If your group life policy does not have a portability option, your protection may end when your association with the group ends. For instance, let's say you quit your job and decide not to continue coverage. Your policy won’t protect you after your last day of work.
Group life insurance has advantages and disadvantages. The policy owner may offer coverage for free as part of a benefits package (and without requiring a physical exam), and for less than you’d pay for a personal term life policy. But there may be a limit on the amount of the death benefit.
Some employer group life insurance policies base coverage on a multiple of your salary. This may not provide enough protection for people who earn lower wages. And if the policy is carried directly or indirectly by an employer and your coverage exceeds $50,000, the IRS will consider it a taxable fringe benefit.
No-Exam Life Insurance
You can buy a no-medical-exam policy through a simplified or accelerated underwriting process. These styles of underwriting ask health questions, but don't require a medical exam. They also may be more expensive than the traditional options described above. For example, such policies may be referred to as "instant issue" or "express."
Another way to avoid a medical exam is to buy a "guaranteed issue" policy that asks no medical questions or to buy burial insurance. These types of whole life insurance policies have a small death benefit amount, such as $25,000, that is intended to cover funeral and burial costs and other final expenses.
If you already have term life insurance, you may be able to avoid taking a medical exam by converting it to a whole life or universal life insurance policy. This may also be an option with your employer-provided life insurance when you leave your job. Talk to your insurance company or HR department for details.
Choosing Between Different Types of Life Insurance
Choosing the right type of life insurance requires you to consider your circumstances and what you want a policy to achieve. Term life policies provide great protection when you have a mortgage or young children and need coverage for up to 30 years. Folks who are young and single with no dependents may only need the limited coverage offered by an employer group insurance policy. This may provide enough money to pay funeral and burial expenses.
Permanent life policies are a great way to provide an inheritance for your family. If you purchase coverage while you’re young and healthy, you may enjoy a lower premium.
Consider Your Goals
Before purchasing a life insurance policy, decide what you want the death benefit to accomplish. Determine your coverage level based on realistic factors, such as the amount of money your surviving spouse will need to replace your income for a few years or pay off a mortgage. Avoid high-risk policies such as variable life insurance if you have little or no financial experience. But consider the potential gains if you’re a seasoned market watcher.
Since permanent life insurance policies earn a cash value over time, also consider long-term goals that the savings might help achieve while you’re alive, like buying a home or taking a dream vacation.