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

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 the policy and the policy is active, or in force, a death benefit will be paid.

Term insurance is initially much less expensive when compared to permanent life insurance. Unlike most types of permanent insurance, term insurance has no cash value. In other words, the only value is the guaranteed death benefit from the policy.

Key Takeaways

  • 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, 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 from term to permanent insurance.

How 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 ten, 20, or 30 years. These are often referred to as "level term" policies. A premium is a specific cost, which is typically monthly, that insurance companies charge policyholders to provide the benefits that come with the insurance policy.

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

The premiums are fixed and paid for the length of the term. If the policyholder dies prior to the expiration of the policy, the insurance company will pay out the face value of the policy. If the term expires and the individual dies afterward, there would be no coverage or payout. However, policyholders can extend or renew the insurance, but the new monthly premium will be based on the person's age and health at the time of the renewal. As a result, the premiums could be higher for the renewed policy versus the original term policy that was initiated when the individual was younger.

Example of Term Life Insurance

Premiums can range depending on the age and the amount of payout. For example, a 30-year policy with a $250,000 payout can range from $15 per month for a person in their twenties to $60 per month for someone in their fifties. Of course, each insurance company might have different rates depending on 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 $27.42 a month. Because of her typically longer lifespan, the average 30-year-old woman can purchase the same policy for just $21.74.

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.

Convertible Term

Convertible term life insurance allows a term insurance policy, which has a limited number of years before expiring, to convert into whole life or permanent insurance. The major benefit of convertible insurance is that the policyholder 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 in life when they have a lot of bills and expenses. The increasing term prevents having to qualify for another policy at an older age to get the added 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 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 term insurance, the premium payments remain constant even as the benefit declines.

Annual Renewable

As each year passes, the term 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 years, 20 years, 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). It also accumulates cash value that you can withdraw or borrow against why 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 it is simpler to understand than “permanent” 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. There are some drawbacks, however. If you have to let the policy lapse within the first few years, you could face surrender charges, and any outstanding loans will reduce your death benefit.

Advisor Insight

Steve Kobrin, LUTCF
The firm of Steven H. Kobrin, LUTCF, Fair Lawn, NJ

Term insurance has two features that make it attractive:

  1. A guarantee on the premium and survivor benefit for a defined amount of years, depending on the company, age of the insured, and other factors.
  2. No capability of accumulating cash inside the policy. You can't pay an extra premium to get extra benefit. You can’t transfer money from other accounts into the policy. The carrier will not pay dividends or apply interest to your account.

This product is ideal for covering yourself for a single need, for a specific amount of time. An example is indemnifying a mortgage or business loan.

The kicker is that if you outlive this time and still need coverage, the price of term insurance typically increases astronomically after the guarantee period.

What Is Term Life Insurance?

A term life insurance policy is the simplest, purest form of life insurance: You pay a premium for a period of time—typically between 10 and 30 years—and if you die during that time a cash benefit is paid to your family (or anyone else you name as your beneficiary).

Do You Get Your Money Back at the End of a Term Life Insurance Policy?

If you're alive when the term expires, you get nothing back from your term life insurance policy. It is a death benefit, payable to your heirs only if you die. That is the reason why term life insurance is relatively inexpensive. Most people outlive their term life insurance policies.

Which Is Better: Term Life Insurance or Whole Life Insurance?

It depends on your family's needs. Term life insurance is a relatively inexpensive way to provide a lump sum to your dependents if something happens to you. If you are young and healthy, and you support a family, it can be a good option. Whole life insurance comes with substantially higher monthly premiums. It is meant to be renewed for as long as you live, and
as the coverage matures the policy grows in value and the policyholder can make withdrawals for any purpose. So it can serve as an investment product as well as an insurance policy.

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, 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 from term to permanent insurance.

Article Sources
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  1. Policygenius. "Understanding Term Life insurance Rates."

  2. Insurance Information Institute. "What Are the Different Types of Term Life Insurance Policies?"