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How does life insurance work?

Fact-checked with HomeInsurance.com

There are several major milestones most people work towards in life. Career, marriage, having kids, buying a home, sending kids to college and retirement. Regardless of where in your life journey you may be, planning for future milestones is essential. One milestone most people don’t like to discuss much is what you leave behind to your loved ones when you die. You can’t predict when that will be, but you can ensure your loved ones are financially cared for when it happens. 

That’s what life insurance is for. Are you wondering “how does life insurance work” and if it’s worth the expense? This article will explain the purpose and function of life insurance, who needs it and how it’s priced. 

What is life insurance?

Life insurance is similar to other forms of insurance such as auto and homeowners, except that instead of paying for damages and replacement costs, it pays a death benefit to your beneficiaries. 

Car insurance pays for accidents and injuries associated with driving, homeowners insurance pays for repairs and replacement to your home and property and life insurance pays those you name as beneficiaries a sum of money after you pass away. 

Insurance and financial expert Laura Adams explains: “The purpose of life insurance is to provide financial protection for anyone who depends on you physically or financially. It can give you peace of mind that your loved ones, such as a spouse, partner, children, or parents, would receive a lump-sum payment, known as a death benefit when you die.”

Who needs life insurance?

How do you know if life insurance is necessary? If you have people that depend on you financially, such as a spouse or partner, children or disabled siblings, for example, having life insurance is a smart decision. 

Ask yourself, how would their lives change without the support they receive from you? Will you leave behind outstanding debts or immediate expenses that need to be paid off? 

A life insurance policy will pay them a sum of money when you pass away that can provide for these necessities. It won’t replace you, but it will at least provide them with financial stability.

How much life insurance do you need?

Knowing how much life insurance you need depends on many factors. Adams says, “Consider your current assets, debts, and goals, such as sending children to college, leaving a charitable gift, or allowing a surviving spouse to be debt-free.”

Let’s use a 35-year-old married man with a wife and two young kids as an example. He’s thinking of leaving his spouse a death benefit, but not sure of how much. To determine what he can afford to leave, he compares the cost of a life insurance policy for three death benefit amounts — basic funeral costs and expenses ($5,000 – $10,000), burial costs, and outstanding debts ($45,000). He decides he can afford to pay for a policy of $75,000.

Keep in mind that the payout your beneficiaries will receive is tax-free — if the payout is $75,000, the beneficiary will receive the full $75,000 without any tax implications.  

How life insurance works

There are several types of life insurance to choose from, although they all work in a similar way. Let’s answer the question, “how does life insurance work?” Once you purchase a policy for a certain payout amount after you die, you’ll need to name who will receive the money. The individuals you designate as the recipients are called beneficiaries. It’s best to specify beneficiaries who are 18 years of age or older to keep things simple. 

You’ll pay a premium each month or quarter. If you buy term life insurance, the policy is only in effect for the set time period. If you die during the term, your beneficiaries will receive the payout amount tax-free. If it’s a permanent policy, the policy doesn’t expire until you cancel it. Once you die, your beneficiaries will receive the payout amount tax-free.

These life insurance terms will come in handy:

  • Premium: The monthly cost of your life insurance policy
  • Term: The length of the life insurance policy before it expires
  • Beneficiary: The individual(s) who will receive the payout
  • Death benefit: The payout your beneficiaries will receive
  • Cash value: When you have a permanent life insurance policy, you’ll have a cash value account besides the death benefit. You’ll be able to draw from the cash value.

How does term life insurance work?

Term life insurance is the simplest type to understand and the most affordable policy to buy. You can buy an insurance policy for a term of 5, 10, 20 or 30 years, for example. You’ll have a set premium that doesn’t change over the term. If you die before the policy expires, your beneficiaries will receive the payout amount of the policy.

Term life insurance is a good option for most people, although younger, healthy applicants will find the cheapest options — the premiums can be as low as $10 per month. As you get older, term life insurance gets more expensive. 

How does permanent life insurance work?

Permanent life insurance doesn’t have an expiration date like term life insurance — as long as you are alive and paying for the policy, it’s in effect. There are two parts to a permanent policy — the death benefit and cash value. Because you’re paying for both, permanent life insurance is more expensive than a term life policy.

Although permanent life insurance costs more, it has several benefits. There’s no expiration date, so you will see a return on your premiums. And since you’re paying towards the death benefit and a cash value account, you’ll be able to access the growing cash value balance throughout your lifetime. You can withdraw from the cash value or borrow from it and pay it back — all without affecting the death benefit. Take a closer look at the types of permanent life insurance.

How does whole life insurance work?

Whole life insurance is the simplest permanent life insurance product. Like term life, you’ll know what your monthly premium will be for the life of the policy. Compared to term life insurance, it doesn’t expire. Plus, it comes with a cash value account, which earns interest on the balance. 

It’s likely that a whole life insurance policy will be more expensive than a term life policy because you’re paying towards a death benefit and cash value. But the good news is you can access the money you’re putting into the account during your life.

How does universal life insurance work?

Universal life insurance adds more flexibility to your permanent life insurance policy. You’ll have flexible premiums, which means you can set the frequency and amount of your premium payments, depending on whether you want to grow your cash value faster. In addition, you can invest the cash value into a mutual or index fund to grow your money faster. 

Other permanent life insurance options

There are other more complex types of permanent life insurance products. They include variable, variable universal and survivorship life insurance. Variable life insurance products are the most aggressively invested in the stock market and as the name implies, their value is variable — they may grow and lose value, depending on the market. 

Survivorship life insurance used to be known as a “second-to-die” policy. It’s a joint life insurance product typically used by spouses. The policy insures both people at once and will only pay out when the second insured passes. It’s a good option when a couple wants to leave benefits to children or heirs only after they both die.

How is life insurance priced?

When you apply for a life insurance policy, the underwriter takes many factors into account to decide on how to price the policy. The most important factors are age and health. Younger applicants usually have cheaper premiums than older individuals. That’s because a 58-year-old is more likely to die sooner than a 26-year-old.

Besides age, health can significantly affect your premiums. In fact, some people with medical conditions such as diabetes, cancer or heart disease may not be able to purchase life insurance. In many cases, you’ll need to pass a medical exam before you’re approved for life insurance. If you smoke or have certain medical conditions, your premiums will be much higher.

The takeaway

  • Life insurance provides financial help to your loved ones after you die.
  • The payout your beneficiaries receive is typically tax-free.
  • Term life insurance has an expiration date, permanent life insurance covers you as long as you continue to pay your premiums.
  • You can leave a small payout to cover your funeral expenses or a large six- or seven-figure payout to cover college for your kids and replace your salary for several years.
  • The cost of life insurance depends on whether you’re buying term or permanent life insurance, your age and health.

Life insurance is an important component of financial planning. While most term policies are designed to provide for outstanding debts and immediate expenses following your death, you could also invest in a permanent life insurance policy to leave family a payout and grow cash value you can tap into throughout your life. 

When deciding on which life insurance policy is best, take the time to compare quotes on different death benefit amounts to find the most affordable option. Buy life insurance when you’re young and healthy to get the lowest rates on life insurance.

Cynthia Paez Bowman

Writer

Cynthia splits her time between Los Angeles, CA and San Sebastian, Spain. She travels to Africa and the Middle East regularly to consult with women’s NGOs about small business development.

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