What Is Term Insurance? How Does It Work, and What Are the Types?

Term life insurance is a type of life insurance policy that provides coverage for a certain period of time, or a specified “term” of years. If the insured dies during the time period specified and the policy is active, or “in force,” then a death benefit will be paid.

Term insurance is initially much less expensive compared to permanent life insurance, such as whole life and universal life. This is because it’s not designed to last through old age, which is when life insurance premiums are the most expensive. And, unlike most types of permanent life insurance, term life insurance has no cash value.

How Term Life Insurance Works

There are various types of term insurance policies available. Many policies offer level premiums for the duration of the policy, such as 10, 20, or 30 years. These are often referred to as “level term” policies. A premium is a specific cost, typically monthly, that insurance companies charge policyholders to provide the benefits that come with the insurance policy.

The insurance company calculates premiums based on health, age, and life expectancy. A medical exam that reviews the insured person’s health and family medical history might be required, depending on the type of policy chosen.

Premiums are typically fixed and paid for the length of the term. If the person insured dies prior to the expiration of the policy, then the insurance company will pay the death benefit to their beneficiaries. If the term expires and the individual dies afterward, there would be no coverage or payout. However, the policyholder can often extend or renew the insurance, but the new monthly premium will be based on the person’s age at the time of the renewal. As a result, premiums are higher upon renewal.

Many term policies are also “convertible,” which means they can be converted into a permanent life insurance policy, such as universal or whole life, within a certain number of years after the policy was taken out. If you convert term life insurance to permanent life insurance, the premium will increase.

Example of Term Life Insurance

Premiums can range depending on the age and the amount of payout. For example, the premium for a 30-year policy with a $250,000 payout can range from $15 per month for a person in their 20s to $60 per month for someone in their 50s. Of course, each insurance company has different rates depending on policy features, such as living benefits and convertibility, as well as the policyholder’s health, history of smoking, and other factors.

The average 30-year-old man can get a 20-year term policy with a $500,000 death benefit for $29.33 a month. Because of her typically longer life span, the average 30-year-old woman can purchase the same policy for just $22.99.

Types of Term Insurance

There are various types of term insurance besides the level term policies we’ve outlined so far. Each policy has its pros and cons, depending on the needs of the policyholder and their beneficiaries.

Convertible Term

Convertible term life insurance allows a term insurance policy, which has a limited number of years before expiring, to be converted into whole life or universal life insurance. The major benefits of convertible insurance is that the policyholder gets lifelong coverage and doesn’t have to submit to a medical exam, nor are any health conditions considered when the term policy converts to permanent insurance.

Increasing Term

Some policies allow you to increase the death benefit as time goes on. The premium increases as well, but it allows policyholders to pay lower premiums early on. The increasing term prevents having to qualify for another policy at an older age to get the added death benefit, as would be the case with traditional term insurance.

Mortgage Term or Decreasing Term

A mortgage term or decreasing term policy is the opposite of the increasing term because the death benefit amount decreases over time. The goal is typically to match the decline of the term benefit to the reduction of the policyholder’s outstanding mortgage. The idea behind this strategy is that you don’t need as much life insurance if you have less mortgage debt. However, although the premiums are smaller than level-benefit term insurance, the premium payments remain constant even as the benefit declines.

Annual Renewable

As each year passes, annual renewable term (ART) insurance is renewed but for a higher premium since the policyholder is a year older. The benefit to annual renewable term insurance is that the coverage is guaranteed to be approved each year. However, it may not be the most cost-effective for everyone due to the increased costs over time.

Term Life Insurance vs. Whole Life Insurance

Term life insurance is perhaps the easiest form of life insurance to understand because it offers a defined death benefit for your beneficiary should you pass away while it’s in force. As the name suggests, this stripped-down form of insurance is only good for a certain period of time, whether it’s five, 20, or 30 years. After that, the policy expires.

This can be contrasted with whole life insurance: a form of permanent life insurance that lasts your whole life (as long as you pay the policy’s premiums). Whole life insurance also accumulates cash value that you can withdraw or borrow against while you are alive.

These two types of insurance offer different benefits. Generally, term insurance has a much lower cost than other types of life insurance, sometimes by a significant margin, and is simpler to understand than permanent insurance policies. On the other hand, protection is only available for the term of the policy, and it cannot be used as a wealth-building or tax-planning strategy.

Whole life insurance is more expensive, but you can lock in your premiums for life. With this type of insurance, you also generally have the ability to borrow against the policy for future financial needs. Loans taken from your insurance, like death benefits, are generally tax free. However, there are some drawbacks. If you let the policy lapse, you could face surrender charges, and any outstanding loans will reduce your death benefit and could become taxable.

The Bottom Line

Term insurance is a type of life insurance policy that provides coverage for a certain period of time or a specified “term” of years. If the insured dies during the time period specified in a term policy and the policy is active, then a death benefit will be paid.

Many term policies offer level premiums for the duration of the policy. Other term policies offer decreasing or increasing benefits over time, as well as the option to convert to permanent insurance.