How Does a Term Life Insurance Work?

An Ultimate Guide on How a Term Life Insurance Work

A term life policy is a contract between you and an insurance company: You agree to pay a monthly premium for a specific term; in return, the insurance company promises to pay a specific death benefit in cash to one or more named beneficiaries upon your death. Beneficiaries are typically a spouse or child, but they can also be a trust, charitable organization, or even a friend. The death benefit they receive is almost always paid out income tax-free – unless the premiums are paid with pre-tax dollars.

As we’ve noted, these policies provide coverage for a limited term or period of time. As you apply for a policy, you need to decide how long you want coverage to last. If you have children, a popular rule of thumb is to choose a term long enough to see them out of the house and through college. The longer your term, the more you’ll typically pay each month for a given coverage amount.

But if you choose a shorter term, you may end up paying more in the long run: when you apply for new term coverage in, say, 10 years, rates will likely be much higher. It’s generally easier and less costly to get insurance while you are younger and in good health.

Most policies require a medical exam during the application process to evaluate your health and learn more about your occupation and lifestyle. Certain hobbies like scuba diving are deemed risky to your health, which may raise rates. Likewise, dangerous occupational environments – for example, an oil rig – also may raise your rates.

Types of Term Life Policies you can buy

All term life insurance policies provide a guaranteed death benefit over a specific term, but there are different types of term policies with varying features and rate structures.

Level premium: Also called level term, this is the most common type of policy and the simplest to understand: Your premium stays the same for the entire term.
Yearly renewable term: This policy, sometimes called an annual renewable term life, covers you for one year at a time, with an option to renew without a medical exam at the end of the yearly term. However, the cost can go up with each renewal. Compared to a level term policy, your premiums will be slightly lower at first, but over a full 10, 20, or 30-year timeframe, you will typically pay more than you would with a level premium policy.
Return of premium: This type of term policy actually pays back all or a portion of your premiums if you live to the end of the term. However, your premiums could be 2-4 times higher than a level term policy.
Guaranteed issue: These policies don’t require a medical exam and only ask a few simple health questions. However, the insurance company will assume you are a risky prospect, so your premiums may be much higher. Also, the policy might not pay a full death benefit for the first few years of coverage.
Decreasing term life insurance: This is a specialized type of policy, in which the premium and death benefit payout gradually decrease each year. It is typically used to cover mortgage obligations.

How to Choose between Whole and Term LifePolicies

While term life insurance can provide the most coverage per premium dollar, with this type of coverage there’s a good chance you’ll pay premiums for many years, live to the end of your policy term, and never see a payout. Another insurance option is a permanent policy, such as whole life insurance, which can provide:

Life-long coverage4
A tax-efficient cash value component with guaranteed growth
Tax-efficient access to the policy’s cash value5

Whole life insurance premiums are higher than term, but the policy’s cash value can provide several benefits that you can use while you’re still alive: You can borrow against your policy’s cash value, use it to pay premiums, or even surrender it for cash to help supplement retirement income. With a mutual company, such as Guardian, whole life policies can also earn annual dividends which can further increase your cash value and/or provide other benefits.6 A term policy has no cash value component.