Life Insurance 101

If you're evaluating your insurance needs and considering life insurance, it's important to understand the basics. Life insurance can be a reliable (and flexible) way to help your family and others who are left behind after you’re gone.

How does life insurance work?

This is life insurance a nutshell: when you purchase a life insurance policy, you pay premiums (typically monthly or yearly payments). These payments keep your policy active, and if you die while your policy is in effect, the life insurance provider will pay out death benefits to your beneficiaries according to your wishes. There are several types of life insurance and some considerations you need to keep in mind.

What does life insurance cover?

Although the concept may be unpleasant to think about, at its core life insurance is designed to help cover loss of income, funeral expenses, and other financial needs that will be faced by those you care about in the event you die. Many people who purchase life insurance policies designate that the benefits from that policy cover end-of-life costs like a funeral and related logistical expenses. Life insurance is a flexible product that can be used in a number of ways – including helping your family cover their living costs or pay your outstanding debts. Some people even use these policies to provide for charitable gifts to organizations they care about.

Types of Life Insurance

What is term life insurance?

A term policy is purchased for a certain period of time frame (known as a term), and then it ends. Typical term policies may be 1, 5, 10, 20 or 30 years. These policies make a larger coverage amount (e.g. $1,000,000) available at a lower cost than whole life/permanent life insurance. Term life insurance policies are usually easier on your budget and are designed to be in effect when needed most – for example, to provide for your surviving spouse in the event you die while your children are young. Most of the time, people who buy term insurance never see a payout, either because they let the policy lapse or because they live longer than the term set. Another reason to get term life insurance is because you might have other income available at a later time – for example, retirement benefits.

What is permanent or whole life insurance?

A whole life (permanent) policy is different in that it will pay your beneficiaries whenever you die. Whole life costs more because you are purchasing a policy designed to provide a death benefit whenever you die – the policy is in effect until your death instead of for a set number of years. These insurance policies are more expensive because you are paying the average premium required to cover the cost of insurance over much longer periods of time. Logically, a policy that covers you for up to 120 years will cost more than a term policy designed to cover only 10 years.

What type of policy should you get?

In determining the basic question of what type of policy to get, you need to balance your costs and your needs. You may not be able to afford higher premiums of whole life (permanent) life insurance, so you may choose a term policy to provide coverage when the need is greatest.

Every person's life circumstances are different, and it may be beneficial for you to get advice from a financial expert before you purchase a policy. Although financial bloggers or commentators you see in the media may have strong opinions about certain financial products like life insurance, remember that financial products are tools. The tool that works in one situation for one person will be different from the tool that works in a different situation for a different person.

How much life insurance do I need?

Once you've decided what kind of insurance policy to buy, you need to decide how much insurance to purchase – i.e. how much the payout will be if you die. Most life insurance companies start with $100,000 minimum death benefits but some companies offer coverage as low as $50,000. In the other direction, the sky is the limit, with multi-million dollar policies available. Deciding how comes down to one basic question: What would life be like financially for those you care about if you were no longer here?

Again, this is an unpleasant question to think about, but if you want to protect the people you care about, you need to take stock of your needs today. If you buy too little coverage, your family might not receive all the financial protection you would like them to have if you pass. And if you buy too much coverage, you’ll be paying a higher premium now – meaning that money cannot benefit your family right now.

When should you get insurance?

If you're younger and single, your life insurance policy can help you plan for the future while you're healthy, which in turn can keep premium prices down. You may want to get insurance to help you cover debts that you don’t want to pass on to your family members. You may also want to provide financial support for aging parents or siblings.

If you're newly married, you may want to use your policy to help cover your household's daily living expenses (such as your mortgage or utility bills) if you pass. Your benefits will also help ensure that your spouse is able to pay off any outstanding debts and your burial expenses. If you have children, you probably want to provide for your kids, too.

If you are nearing retirement and had coverage that was previously paid for by an employer, you may want to buy your own coverage if your employer-paid coverage ends when you retire. If you're already retired, you may want to buy life insurance to allocate as an inheritance or make a charitable donation, to cover the cost of estate taxes, or to replace income for a loved one that you previously received from a pension.

Whatever age you are, check out our article on evaluating your insurance coverage for more helpful tips.