By guest financial blogger, Daniel Mattia
You’ve heard of life insurance before, whether on a commercial or when signing up for employee benefits. But what exactly is life insurance, and why do you need it?
Simply put, life insurance provides a cash benefit to your loved one(s) if you pass away. While you may no longer be around to provide for your family, their financial health will still be protected through your life insurance policy.
But life insurance can be used for more than just final expenses.
Life Insurance: Not Just for Funerals
Eighty-five percent of Americans who own life insurance do so to cover burial and final expenses, according to LIMRA.
That makes sense. The average cost of a funeral in America is $7,000 to $10,000. Thousands of dollars is a hefty price-tag to contend with while trying to cope with the grief of losing a loved one.
That’s not counting other debt left behind in your wake, either.
In fact, nearly three-quarters of Americans pass away while holding $61,554 of debt, according to a recent report.
Depending on your stage in life, your debt is likely spread across:
- Student loans
- A mortgage
- One or more car loans
- Credit cards
- And other loans
Those bills don’t fade away after death. Your family will have to tap into its assets (if there are any), rely on family or charity, or substantially transform their lifestyle — all while dealing with the loss of a loved one.
Enter life insurance. Life insurance can provide coverage that extends far beyond the cost of an average funeral or burden of debt. And there’s no stipulation to how that money is used.
In addition to relying on life insurance for final expenses, the same LIMRA report states:
- 67 percent of policyholders have life insurance to replace lost income from the death of a wage earner
- 63 percent plan to use life insurance to transfer wealth or leave an inheritance behind
Term Life vs. Whole Life Insurance
Life insurance is commonly sold in one of two forms: term life or whole life.
Both term life and whole life insurance function in much the same way: you pay your premium (usually monthly) in exchange for coverage, the death benefit.
Both term and whole life pay out a death benefit upon the passing of the insured. This is the amount of money that would go to a beneficiary — the person you choose to receive the proceeds of a life insurance policy.
Where the policies differ is in the duration and, ultimately, total coverage and cost.
Term Life Insurance
Term life insurance is simple life insurance. It provides coverage without any bells and whistles. Most term policies require you only to pay a level premium for the duration of the term. As long as you do, your coverage will remain in force. (Some term life insurance policies do not have level premiums, but this depends on the insurer.)
It’s also totally possible for you to outlive term life insurance. That’s actually what you should hope for.
As its name implies, term life insurance lasts for a period of time of your choosing. In most cases, a term is between 10 and 30 years, but term lengths may vary depending on the insurance company (also known as the insurer).
If you pass away during the term of your policy, no problem — the policy pays out. If you outlive the policy, it simply expires.
Your intention when buying term life should be to outlive it. That’s because term life insurance provides an affordable way to maintain a substantial amount of insurance coverage for a low, level premium over its term — during a time when you’re most financially vulnerable.
Experts often recommend your insurance coverage equals 10 to 12 times your annual income. Term life helps you buy that coverage. Such ample coverage is enough to support your family when you’re no longer around to continue doing so, especially if you pass during your earning years — before you’ve had that big promotion or enough time for your investments and assets to build.
But what then? You’ll likely still have some need for insurance.
Whole Life Insurance
Whole life insurance provides insurance that lasts — you guessed it — for your whole life. Many even refer to whole life insurance as “permanent life insurance.” As long as you pay your premiums, whole life insurance is guaranteed to pay out because we all pass away eventually.
But there’s a trade-off for that guarantee.
Dollar-to-dollar, whole life is more expensive than term life insurance. That’s because whole life insurance is geared toward those in a different part of their lives with higher incomes or complicated tax situations. After you’ve had time to accumulate assets and pay down debt, your insurance needs have diminished (but not evaporated).
It provides insurance coverage that will still reduce the impact of your passing on your family’s finances, but not as much coverage to pay off large bills, like an entire mortgage or early life debt.
Whole life insurance is a little more complex than term life, too. While the premiums of a whole life policy are usually level throughout the policy, a portion of each premium helps build a whole life policy’s cash value.
Whole life policyholders can tap into cash value to:
- Purchase a paid-up policy (a smaller policy paid in full based on a single premium payment made by the accumulated cash value)
- Purchase paid-up additions (increased death benefit)
- Pay premiums via cash value
- Take out a loan
- Make a withdrawal
In each case, tapping into cash value reduces the overall death benefit of the policy, but helps to keep a policy in force if it’s otherwise unaffordable. Sometimes, based on your specific financial circumstances, a whole life policy can even be used to supplement your retirement income, but that’s a decision best made on the advice of your financial advisor.
Qualifying for Life Insurance
Premiums for either type of life insurance are based on a number of risk factors. These sometimes vary from insurer to insurer, but often include:
- Your age at the time of purchase
- Your health
- Your smoking status
- The amount of coverage you’re trying to buy
- The length of the term (for term life insurance)
In some cases, an insurer will require you to undergo a medical exam or otherwise take into account your medical history. This is a process called underwriting. In general, the healthier and younger you are, the more affordable your premium.
Some insurance (most commonly final expense life insurance, a form of whole life insurance) is “guaranteed-issue.”
A guaranteed-issue life insurance policy is available to almost anyone, regardless of their health. That coverage, however, comes at a price. Because applications for guaranteed-issue life insurance do not ask many (if any) medical questions, almost anyone can qualify for coverage — including those in poor health or with a terminal illness.
Guaranteed-issue life insurance is more risky than an underwritten alternative. Insurers offset some of that risk by charging higher premiums than they would for a policy that takes an applicant’s medical history into account.
Choosing a Beneficiary and the Death Benefit
When buying a policy, you’ll want to assign a beneficiary or beneficiaries. This determines who the death benefit goes to after your passing. Common beneficiaries are spouses and children, but nearly anyone (or entity) can be assigned as your beneficiary.
Upon filing a claim against your policy, your beneficiary will receive the policy’s death benefits tax-free. This money can be used for anything, so if you have special final wishes, make sure your beneficiary is someone you trust to carry them out.
With a large enough policy, you can leave behind a gift, settle your family’s remaining debt, or contribute to your grandchildren’s college fund.
Who Needs Life Insurance?
Unless no one depends on your income or you’ve accumulated sizable assets, you very likely need life insurance.
When you’re young, you likely have substantial unpaid debt, have or are planning to have children, and haven’t yet reached your full earning potential.
Later in life, your financial situation and goals change. Your debt has likely diminished, you’ve built up assets, and your income has increased. Still, your goals might include going on a vacation, establishing or contributing to a college fund for your grandchildren, or paying off the remainder of your mortgage.
In each case, life insurance will protect your family from the sudden loss of income following your death.
If you purchased a policy equivalent to 10 times your annual income, that’s a huge buffer to help your family properly grieve without worrying about finances. But even a policy that covers just your final expenses and a few months of bills can give your loved ones valuable time to mourn.
Later in life, your priorities have shifted but the need for insurance hasn’t disappeared. Life insurance can supplement the Social Security and pension payments made to your widow, pay for your funeral, or be left as a gift to a charity or grandchildren.
How Much Life Insurance Do You Need?
First, determine how much life insurance you need. Any life insurance policy you buy should reflect your budget, short- and long-term goals, and personal preferences.
Consider your total income vs. expenses. How much income would your family lose if you were to pass away? What total expenses would they still be on the hook for? What other situations, such as college tuition, would you like your life insurance to go toward?
Such calculations will give you an idea of how much life insurance you should consider buying — and what type. If you’re young and still getting your life started, term life is likely a better choice than whole. But if you’re in a good financial place with minimal (if any) debt, whole life may be a more fitting and affordable option.
While life insurance isn’t the most exciting purchase you’ll make in life, it’s certainly an effective solution for protecting your family. You and your loved ones can rest easy with the knowledge that they’ll be provided for after you move on.
Daniel Mattia is a contributor to the Bestow blog and freelance writer. He specializes in writing data-driven evergreen content for startups and small businesses. Daniel can be contacted and hired at http://danmattia.com