How Life Insurance Works: A Beginners Guide

Have you been putting off life insurance? It’s not easy to think about a possible future where you’re not around to care for your loved ones and provide for your family.

Life insurance allows you to protect your dependents even if you’re not around to care for them. With the right policy in place, you can ensure your loved ones won’t be burdened by unexpected funeral expenses, medical bills, or mortgage debt that you leave behind. Even after you’re gone, you can be sure you will provide a college fund for your children and leave enough to cover the loss of your income for your family.

Taking care of your loved ones is the easy choice. What can be a bit tougher is choosing the right type of life insurance for you, your financial goals, and your family.

How Life Insurance Works

Life insurance is a contract between you and an insurer. You pay a premium for a policy, and, in the event of your death, the insurer pays a sum of money (also known as death benefit) to your beneficiaries.

Your beneficiaries can use this death benefit to replace the income that you provide, to care for dependents, pay for funeral, burial, medical, and/ or probate expenses, or pay off your mortgage and other debt. Your life insurance can even be an inheritance for your heirs and provide a college fund, wedding fund, or provide for a down payment on a home for your children.
 

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Term vs Permanent Life Insurance

Life Insurance may feel complicated, but it can really be simplified into two different types of policies: term and permanent.

Term Life

Term life insurance is the most popular and simplest form of life insurance.

With a term policy, you select a term (coverage period) ranging from one to 30 years. The policy pays a benefit if a death occurs during that specified term. Term premiums are consistent and typically very affordable.

Here’s how it works:

If you choose a 20-year term policy, for example, your premiums remain consistent over those 20 years. If you were to die during that coverage period, your beneficiaries would receive the death benefits outlined in your policy. At the end of those 20 years, your coverage period is over. If you have outlived your policy term, no benefits will have been paid out.

When your term policy ends, you can purchase a new life insurance policy. Some term policies are convertible, which means you have the ability to convert it into a permanent type of life insurance.

Permanent Life

Permanent life insurance offers guaranteed lifelong death benefit protection. Whether you die tomorrow, in ten years, or live to be 100, your permanent policy is guaranteed to pay out a death benefit, as long as you’ve paid your premiums and maintained your policy.

With permanent policies, you can lock in premium rates; they won’t increase as you age or if your health declines. There are additional benefits to a permanent policy outside of lifelong coverage and guaranteed rates, as well.

Permanent life insurance typically includes a cash savings component. A portion of your permanent life insurance premium may be invested, which can accumulate a cash value over time.

Permanent life insurance is typically substantially more expensive than term insurance.

Term policies are primarily created to last only for a finite period of time that will likely end before you die. In most cases, the insurer does not have to pay a death benefit for a term policy. In comparison, permanent policies are designed to exist until you actually leave this earth, guaranteeing a payout. Insurance companies charge more when they know they’ll be paying out a death benefit.

The second reason that permanent policies cost more than term policies is the cash value component attached to the policy. With permanent life insurance, one portion of your premium goes towards the death benefits, while the other portion of your premium is set aside to accrue for your future use.

Permanent life insurance comes in a variety of options, including:

Whole Life
Whole life insurance is the most common type of permanent insurance policy. It offers a death benefit along with a savings account. If you pick this type of life insurance policy, you are agreeing to pay a certain amount in premiums on a regular basis for a specific death benefit. The savings element would grow based on dividends the company pays to you.

Universal Life
Universal life insurance policies offer more flexibility than whole life. The cash value generally earns a money market rate of interest. If you’ve accumulated enough in your account, you typically have the option of altering premium payments. If you’re in a tough economic period and need to temporarily reduce or stop payments, your adjustable life policy may help you do that.

If you have enough cash value accrued, you may be able to use that cash value to lower or skip some premium payments. However, you should always check with your agent before deciding not to make premium payments for extended periods because you might not have enough cash value to pay the monthly charges to prevent a policy lapse.

How Much Life Insurance Do You Need?

There are a lot of choices to make when it comes to your life insurance. Your policy type is one and the amount of insurance you need is another. When determining how much life insurance you need, you can start by asking one, simple question:


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Who Depends on You?

If you do not have any dependents and you have enough money saved up to pay for your final expenses, such as funeral and burial costs and any medical bills not covered by health insurance, you may not have a need for life insurance.

If you have children, adult dependents, or a spouse who rely on your income, however, your need for life insurance definitely increases.

If this sounds like you, you may want to buy enough life insurance to replace your income until your children have grown, pay for college, pay off your mortgage, and cover your funeral and burial expenses.

Also, consider if your family might need extra money to make some changes in the event of your death. For example, they may want to relocate to be closer to grandparents, or your spouse may need to go back to school to be in a better position to help support the family. If you’re the caregiver for an aging parent, you may need enough insurance to pay for them to move into an assisted living facility if something happens to you.

Don’t forget to include “hidden income” that would be lost in the event of your death. Hidden income is income that you receive through your employment but that isn’t part of your gross wages, like your employer’s subsidy of your health insurance premium and matching contribution to your 401(k) plan, which could be the equivalent of $2,000 per month or more.

If you want to create an inheritance or make a charitable contribution, buy enough life insurance to achieve those goals.

Still feel confusing? A good rule of thumb for estimating how much life insurance you need is to buy insurance equal to 20 or 30 times your salary before taxes.

Life insurance doesn’t need to be complicated.

Do you have people who depend on you? Do you want to be assured that your loved ones will be taken care of after you’re gone? Then you need life insurance. Talk to an insurance professional today to help you determine how much life insurance you need, what type of policy will work best for you, and how affordable it can be to make sure your loved ones are taken care of - no matter what.

 

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