How do term and permanent life insurance work?

Understanding how term and permanent life insurance work is essential before you buy a life insurance policy. Term life insurance offers coverage for a specific period, providing a death benefit if the insured passes away during that time. On the other hand, permanent life insurance provides lifelong coverage, with the added benefit of cash value accumulation over time. 

Here’s a detailed look at each type of life insurance policy

Term life insurance

Term life offers the most amount of coverage for the least amount of money. The most common reason to buy life insurance is to replace a person's income in case of an early death. Term life insurance also provides the bigger death benefit for your premiums.

Term life policies last for a specific period, such as 10, 15, 20 or 30 years. Your policy lapses unless you renew or convert the policy at the end of the period. A word of warning: the policy will cost a lot more money if you renew your policy later. Why?

You'll be older. Your age and health status are two important factors in the cost of life insurance. You might be able to convert your term life to permanent life depending on your policy. (Find out more at "6 reasons why you should convert term life insurance to permanent life insurance.")

Permanent life insurance

A permanent policy offers protection for your entire life (as long as you pay your premiums) and more flexibility than term life insurance.

However, it usually comes at a much higher price. One feature that makes permanent life insurance different is its ability to gain cash value. A portion of the money you pay into your premium goes into a cash value account that grows over time and becomes available for your use after a certain period.

Having cash value means you can tap into your permanent life insurance policy if you find you need money later. Some people may even use money from a permanent life insurance policy to help with retirement.

Types of permanent life insurance

There are four main variations of permanent life: whole life, universal life, variable life, and variable universal life.

  • Whole life insurance is a predictable policy. It offers a guaranteed benefit, a guaranteed earnings rate on your cash value and a level premium. You may also earn dividends based on how well the company performs. Whole life is the most basic kind of permanent life insurance.
  • Universal life insurance is a flexible option. It lets you vary your premium payments. After the first premium, you can usually make payments at any time. If you have extra money, you can pay more. If you can't afford to make a payment, you can skip it or pay less. The cash value portion usually operates similarly to whole life insurance. A downside to universal life is that if you don't make enough payments or the company does not perform as expected, your policy could lapse. Newer types of universal life policies include guarantees that this will not happen, so be sure that you explore this option. 
  • Variable life insurance lets you invest your policy premiums. The issue with this is that if the investments perform poorly, the death benefit and cash value will decrease. On the other hand, if the investments do well, the death benefit and cash value can greatly exceed those of a normal policy. Variable life is one of the riskiest forms of permanent insurance.
  • Variable universal life insurance is a combination of variable and universal life insurance. It allows you to vary your payments, invest your policy premiums and vary your coverage amount. Variable universal life insurance is the most flexible type of permanent life insurance and can be either risky or predictable, depending on how you use it.

Which policy is best depends on what you want from your life insurance.

How does cash value work?

The portion of your payment that goes toward the policy's cash value is large in the beginning but decreases slowly as time passes. That's because permanent life insurance payments are made up of two parts: the regular insurance premium, which is comparable to the premium amount for the same coverage in a term life policy, and the cash value, or "overpayment" amount.

The insurance company invests the overpayment money and later uses it to pay for the higher costs of insurance as you age. In this way, the company can keep your premiums the same instead of increasing them over time. This cash value amount becomes available for your use later.

The policy's cash value can work differently and be used for different reasons depending on the type of permanent life insurance you choose. 

Term life vs. permanent life: Which is better?

Buying life insurance is a highly personal decision. There is no one perfect fit for everybody. When deciding to go with either term life or permanent life, you will want to think about why you need life insurance and what you want to get out of it. 

Here’s a comparison between term and permanent life insurance to make your choice easier. 

Term life insurancePermanent life insurance
Term life insurance provides coverage for a specific term or period, such as 10, 20, or 30 years. Once the term expires, the policy terminates unless it is renewed. Permanent life insurance provides coverage for the entire lifetime of the insured individual as long as the premiums are paid. There is no expiration date or need for renewal.
Term life insurance generally has lower premiums compared to permanent life insurance. This is because it provides coverage for a specific term and does not accumulate cash value.Permanent life insurance generally has higher premiums compared to term life insurance. This is because it offers lifelong coverage and includes the cash value accumulation feature.
Term life insurance policies do not accumulate cash value. They are purely designed to provide a death benefit to beneficiaries if the insured dies during the term of the policy.Permanent life insurance policies accumulate cash value over time. A portion of the premiums paid goes into a savings or investment component, which grows tax-deferred and can be accessed or borrowed during the policyholder's lifetime.
Term life insurance is suitable for individuals who have specific financial responsibilities for a fixed period, such as paying off a mortgage or providing for dependents until they become financially independent.Permanent life insurance often includes an investment component, such as whole life or universal life policies. Policyholders have the potential to earn dividends, interest, or investment returns on the cash value portion of the policy, depending on the type of permanent life insurance they have.

After you've decided which type of life insurance policy you want, make sure to shop around to find the right policy for your situation. Research each insurance company's records. You can do this by researching online reviews and checking their financial records. (See's "Best Life Insurance Companies.")

Once you're comfortable with multiple insurance companies, request quotes for the same policies. This includes any riders or extras that you want on the policy. Whether you choose term or permanent insurance, get quotes from multiple companies and figure out which one makes the most sense for you.

Life insurance FAQs

Can you have term life insurance and permanent life insurance at the same time?

Yes, it’s possible to have term life insurance and permanent life insurance at the same time. You can opt for a combination of both to meet your specific insurance needs. Term life insurance can provide a higher amount of temporary coverage during periods of high financial responsibility, while permanent life insurance can provide continued coverage after the term ends. 

What happens to term life insurance at the end of term? 

At the end of the term for a term life insurance policy, the policy will expire, and the coverage will end. If the insured dies after the term has ended, there will be no death benefit paid out to beneficiaries. However, some term life insurance policies may offer the option to renew or convert the policy.