This is part one in a 3 part article intended to make the types of life insurance less confusing. These three articles should be read in order.
- Life Insurance Types – Term life insurance
- Life Insurance Types – Whole Life and Term To 100
- Life Insurance Types – Universal Life Insurance
Note: You can run a term life insurance quote in the right sidebar of this site.
I speak to many people about life insurance every day and one common theme I see is complete confusion over what the various types of life insurance are. Some folks have read up on what the consumer advocates have to say and demand only term life insurance regardless if that’s what’s best. Others just have to have something where they ‘get their money back’, again regardless of whether that’s the best deal or even the right type of insurance. Ultimately I believe this confusion stems from the insurance industry selling products using wild and colorful presentations that focus on just about everything but the insurance aspect. Consumers are confused and skeptical of being sold the wrong type of life insurance.
There’s a fix to that. Quit treating life insurance as a financial product and start treating it as an insurance product. Life insurance is insurance – not a savings or investment account. It’s generally not a tax saving strategy either (occassionally it is – but it’s only a solution to tax problems if you actually already have tax problems. Are you seeking a solution to your tax problems?). Look at life insurance the same way you would your car insurance. Would you consider saving for your children’s education via your car insurance? Do you want all your premiums ‘back’ from car insurance as a savings plan? Of course not. And that’s because we all know our car insurance is an insurance product not a financial product.
In fact, at it’s core life insurance works very similar to car insurance. We pay a premium for a year. If we have a claim (we die) the insurance company pays the benefit. If we don’t have a claim the insurance company uses our premiums to pay the claims of whoever did have a claim. That’s simple enough.
Just like car insurance, if we’re a bad driver our rates go up. What primarily makes us a bad driver with life insurance is our age. Every year we’re a year older, we’re a year closer to dieing. So the way pure life insurance would work is we’d pay a premium for a year and have our coverage. Next year our rates would go up a bit, as they would every year thereafter. Eventually the insurance premiums would be out of site since we’d be such a bad driver (we’d be old).
The product just described does exist. It’s called 1 year term life insurance. It’s 1 year term because the rates go up every year. It’s term life insurance because there’s no bells or whistles or cash values in the policy and the rates basically follow our age. The problem with this product is that no one will buy it. Who’s going to buy a life insurance product where they know the rates are going up every year and eventually will be too expensive? Nobody.
So what the insurance companies did is take the rates over 5 years and figure out the average premium. Using that average premium, they can now provide a product where the rates are level for 5 years, then they go up and again are level for another five years, and so on – basically staircasing upwards every five years. That product is called 5 year term life insurance. 10 year term, 20 year term life insurance, they all work in the same fashion.
If you’re younger and raising a family and need a lot of insurance, term insurance fits the bill. A 20 year term life policy will give you level rates for 20 years; generally long enough to get the kids mostly out of the house and pay down the mortgage. And since the premiums are based on your age and you’re not paying for cash values or other features, it’s pretty much the cheapest type of life insurance available.
However even with 20 year term premiums going up every 20 years, they will eventually get too expensive (in fact most term policies expire around age 70 to 80). So while longer term life insurance is great for many folks, there are some folks who have life insurance needs no matter when they die – 50, 80, 99, or 120. For those folks term life insurance simply won’t work, the premiums will eventually be unaffordable.