How do term and permanent life insurance work?
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 higher coverage at a lower cost because the coverage period is limited. The most common reason to buy life insurance is to replace a person's income in the event of an early death, and that need often diminishes over time as children grow up. Term life insurance will cover you when the need is greatest.
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. Most term policies can be converted to permanent coverage, but rates will likely be higher due to your increased age.
Permanent life insurance
A permanent policy offers protection for your entire life as long as you pay your premiums, and includes a cash account that grows over time. Whole life and universal life are the two most common forms of permanent life insurance.
Permanent life insurance is more costly because it doesn't expire. The cash value can be accessed during your lifetime as a loan or a surrender, but it usually returns to the insurance company when you die if you don't use it.
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.
How does cash value work?
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. This cash value is treated as an investment, earning interest, and accumulates over time.
The insurance company invests the overpayment and later uses it to cover the higher insurance costs as you age. In this way, the company can keep your premiums the same instead of increasing them over time. This cash value can be accessed as a loan or a surrender, and can also be used to pay your premiums, keeping your policy in force if you can't afford to pay them for a while.
When you die, that cash value is returned to the insurance company in most cases, although some policies include a clause that adds the cash value to the death benefit.
Term life vs. permanent life: Which is better?
Term life insurance is better for those who need a high coverage amount for a specified period, such as until their children are financially independent. Whole life is better if you need lifelong coverage to provide a death benefit regardless of when you die; for example, if you want to cover final expenses or leave a bequest to a charity.
Here’s a comparison between term and permanent life insurance.
| Term life insurance | Permanent 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. | Permanent life insurance generally has higher premiums compared to term life insurance. |
| 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. |
How to choose life insurance
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. Compare life insurance companies on reputation and rates to find the best choice for your needs.
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.
FAQ: Term vs. permanent life insurance
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.
