How Does Life Insurance Work? (And Do I Actually Need It?)

Most people would never pick death as a conversation starter. But since we’re talking about life insurance…when you pass away, who's going to pay for your funeral and any other expenses you leave behind? 

Those are great questions. But do I really need life insurance?

If you financially contribute to your household, the loss of your income could be a devastating blow to your family’s funds. One way to make sure your family stays afloat without your income is to invest in a life insurance policy.

Something else to keep in mind: the younger you are, the lower your premium will cost. So it can pay off to invest in life insurance sooner rather than later.

Okay so…how does life insurance work?

Life insurance is a contract with an insurance company. You agree to pay a monthly premium (Psst…here are some general insurance terms to know.) In exchange, the insurance company agrees to pay your chosen beneficiaries a death benefit when you die. Like auto insurance. Except you're the car. Your family can use the payment from the insurance company to pay for your funeral, any debt you owe, or any other expenses.

Those are the basics, but life insurance policies can vary. A lot. Some come with an investment component. Some only cover a specific timeframe. And some even allow you to borrow from your death benefit while you’re alive.

How do I know which life insurance policy is right for me?

There are three different types of life insurance policies to choose from. With different pros and cons.

Term life insurance

If you’re on a tight budget, a term life insurance policy might be the best option for you. That’s because it offers coverage for a lower monthly premium than other policy types. Term life insurance policies provide coverage for a specific amount of time (or term). Usually around 20 years. And if you’re still alive when the term ends, you can switch to a permanent policy. For a higher monthly premium, of course. (PS: Here’s how to make more room in your budget to cover the cost.) Some term life policies offer to refund all or part of your premiums once the term ends. Hint: read the fine print.

Whole life insurance

If having access to your death benefit while you’re alive is important, ask about a whole life insurance policy. Chances are your monthly premium will cost you more than term life, but that’s because they cover, well, your whole life.

Plus, as you pay your premium, your policy builds cash value. How much depends on what’s left over after the insurance company deducts its fees. And you can borrow that money if you need to. For any expense. No explanation needed. (You can't do this with a term policy.) But don’t get too carried away. Borrowing from your policy lowers your death benefit until the loan is repaid. With interest (which is usually lower than other loans).

You can also make a withdrawal — tax-free, up to the cash value of premiums you've paid. Any amount you take above that is taxable. Withdrawing the entire balance would cancel your policy.

Universal life insurance

If you want permanent coverage with flexible premiums, universal life insurance may be the way to go. It doesn’t have an expiration date like a term life insurance policy. And you’ll probably earn more cash than you would with a whole life insurance policy. 

That’s because cash value on this type of policy earns interest based on the market rate. But many policies have a minimum interest rate. So no need to stress about a market crash. 

Another benefit of universal life insurance is flexibility. You can make changes to your death benefit amount or monthly premium if you need to. 

Got it. And how much life insurance do I need?

That depends on your financial situation. The general rule of thumb is around 10 times your annual income. But you might need even more, depending on your assets and expenses. Also inflation. Talking to a financial advisor to analyze your individual situation can help.

theSkimm

Life insurance can help you make sure your family can afford to live without your income when you die. Depending on the policy you choose, you can use your policy to help with expenses while you’re alive. But start looking as soon as you can, because as you get older, the monthly costs can increase.