By David Rodeck
Life insurance comes in two forms: term and permanent. Both types use the same basic setup where you pay for coverage and if you die, your heirs receive a death benefit payment. However, the two formats also have many differences and fit very different needs. It's important to understand both types so you can find the right coverage for you and your family.
Length of coverage
Term life insurance is temporary life insurance. These policies only last for a set period of time, typically five years or 20 years. If you die during this time, your heirs receive the insurance death benefit. If you outlive this period though, your policy will expire and you'll lose your insurance coverage.
Permanent life insurance does not have a set expiration date. When you buy one of these policies, they are designed to last your entire life and will only expire if you stop making your insurance payments. That's why one popular type of permanent life insurance is called whole life; the policies last your "whole life."
Permanent life insurance starts out much more expensive than term. For the same amount of coverage, you'll find that a permanent policy will cost five to ten times as much as a term policy, maybe even more.
Term policies are much more affordable because the majority of them expire without paying out any money. Since permanent insurance is more likely to pay out, insurance companies need to charge more to make up for the upcoming expense.
To keep your life insurance coverage in place, you need to pay insurance premiums throughout the year, usually monthly. Permanent life insurance locks in your insurance cost. You'll pay the same amount for the rest of your life and won't have to worry about premiums going up. Term policies gradually get more expensive over time. Some policies charge more every year while others lock in a price, but only for the length of your policy. Once your coverage expires, you might be able to renew, but only at a higher insurance cost.
Cash value option
Certain permanent life insurance policies build something called cash value. This is money in the policy that you can take out and spend while you're alive. The insurance company invests your cash value so it grows over time. Basically, you're combining a type of savings account with your life insurance.
Term policies never offer cash value. They just provide the life insurance coverage.
Whether you should go with a term or permanent life insurance policy really depends on your needs. Term is good when you need a large amount of coverage for a temporary amount of time, such as when you have young children or are paying off your mortgage.
For most people, completely covering these needs with permanent insurance is too costly, so term makes more sense. Once your kids grow up and you pay off your mortgage, you likely won't need as much life insurance anymore, so it's fine that the term policy will eventually expire.
Permanent life insurance is better for needs that never go away, such as paying your final expenses. We all die eventually and funeral costs can add up to thousands of dollars. It makes sense to have a small permanent policy to cover these upcoming expenses. Permanent life insurance is also good for leaving an inheritance.
The reason that permanent insurance works better for these situations is because you'll always have your coverage. With term, you risk losing your insurance right when you might need it most.
David Rodeck is a financial writer based in New York City. He has worked as a financial adviser for New York Life, and has passed the Series 6 and Certified Financial Planner exams. David has been writing professionally since 2011 and specializes in making investing, insurance and retirement planning understandable. He is also the editor-in-chief at All Financial Advisors.