You may have thought about what will happen to your loved ones financially if you pass away. If you’re married, you may have even joked to your spouse about offing each other for the life insurance payout. (Turns out so many people joke about this, we made an entire commercial about it!)
While you might understand the basic concept of life insurance, there are some nuances you’ll want to get familiar with before applying for it yourself. Here’s how life insurance works, some common terms, and when life insurance might make sense for you.
How life insurance works
Life insurance is a way for you to leave the people you care about money in case you die. Unpleasant to think about perhaps, but life insurance can be an essential part of maintaining financial continuity in your loved ones’ life in the event of your passing away. It’s an agreement between you and an insurance company: you pay a fee (often monthly), also called a premium, and in exchange, the life insurance company provides you with coverage.
This coverage, should your family call on it in the event of your death, is also called a death benefit. It’s an amount chosen by you to be a financial payout in the event of your death. This money can be used by your loved ones or by anyone you designate to do everything from pay day-to-day bills, pay off the mortgage, pay for college, or continue payments to a beloved charity. Note that claims can be denied, for reasons such as fraud or misrepresentation, aka not being completely honest on the application or the claim.
Your premiums depend on a few factors:
- Your personal characteristics, such as your age, health, gender, and more
- The type of insurance you want, such as term life insurance or permanent life insurance
- The coverage amount, or how much money you want to leave your beneficiaries should you pass away.
The life insurance company will collect all this info when you apply to determine your premium amount, through a process called underwriting.
Common life insurance terms
There are lots of different types of life insurance, but to level-set, here are some common terms associated with the industry:
Life insurance application: You need to apply for life insurance through an application. Traditional life insurance applications usually involve a medical exam and about six to eight weeks of paperwork and back and forth. Digital life insurance can be done online and can take as little as five minutes. In the application, you’ll be asked questions about your age, health, family history, and more.
Policy: Your policy is the legal, binding document from the insurance company that states the terms of your contract.
Premiums: This is the amount you pay in exchange for coverage. It’s based on a lot of factors, such as how long you want the life insurance coverage for, your age, your health, and more.
Death benefit: This is also known as the coverage amount, face amount, or payout amount. It’s the total amount that would go to your loved ones should you pass away and they file a claim. You choose a policy death benefit when you apply for life insurance. If it pays out through a claim, it can generally pass to your beneficiaries tax-free.
Beneficiaries: These are the people who will receive the coverage amount.
Term: The term is the length of time your policy will be in effect, such as 10, 15, 20, 25, or 30 years. You can also choose to be covered for your entire life, depending on the type of life insurance you choose.
Filing a claim: This is the process that your beneficiaries will go through to claim the coverage amount.
Underwriting: The process by which an insurance company gathers your personal information, such as age, health, and gender, to determine what premium amount you qualify for.
Do I need life insurance?
You now know the basics of what life insurance is but might be asking yourself when it’s best to get life insurance. The first question you need to ask yourself is, would your absence cause anyone you love financial strain? If you answered yes to one or more of these situations, then you might need life insurance. Here are five of the top scenarios where life insurance might be appropriate.
1. You contribute a meaningful portion of your income to your loved ones
If you support anyone with your income, you’ll want to consider life insurance. Life insurance can be thought of as a way to continue these contributions should you pass away during your policy’s term. The money could go to helping your spouse, kids, parents, or other loved ones with bills like food, housing, and childcare.
2. You have kids
If you have children—whether a stay-at-home parent or a working one–you should consider life insurance. Even if you don’t bring in an income, you likely provide care that does have a real dollar amount, and your family would have to pay for that in your absence. Additionally, if you have children that you think will want to go to college, money from life insurance could contribute significantly to these bills.
3. You have a mortgage or other shared debt
If there’s a loan, such as a mortgage, you’ll want to consider life insurance, especially if someone else has co-signed the loan. That person may be required to continue making payments, so you’ll want to ensure that they are set up for financial success.
4. You own a business
If you own a business, you’ll want to consider life insurance, and it might even be required as part of your loan. Small business owners need life insurance if they’ve taken on debt using personal assets, such as your home, as collateral. If you pass away, life insurance can help pay off those debts. If you co-own the business, you’ll want to look into a policy where your business partner is the beneficiary. That could help him or her buy out your shares at a price you set now. Consult with an attorney if this is relevant to you.
5. You have life insurance through work
Yes, even if you have coverage through work, you’ll want to consider more life insurance, because chances are, it’s not enough coverage. Most group life insurance policies have a cap of one to two times your salary, and could even be as low as a single $10,000 payment—not enough to sustain your family in most cases. Some financial experts suggest that your life insurance coverage should be somewhere between 10 and 15 times your salary.
None of the above apply?
If none of these apply to you but you think they might apply in the future, such as a spouse, children, or business—you might still want to consider getting life insurance now. On the whole, the younger and healthier you are, the better price you could get for your premiums, and for term life insurance in particular, that price gets locked in for the length of the term (i.e. 15 or 20 years). Think about it this way—a 25-year-old will likely outlive a 20-year term policy, but a 65-year-old will not. The pricing is done accordingly, based on age and other factors as mentioned.
You might now be asking yourself, why on earth would I want to pay for a policy now in my 20s when I don’t have a family, kids, or an elderly parent to care for? The premium would in theory be significantly lower now, the price of which you can keep as you go through the next few decades of your life. As anyone who is in their 30s or 40s can tell you, things change and in a hurry. While marriage and kids might not be in the cards for everyone, if you wait until you have those things, life insurance could be more expensive. Think of getting a policy now as insurance against the rising cost of insurance (ha!). Your health also declines as you get older, too, and insurance companies take that into account.