How Does Term Life Insurance Work

The idea behind term life insurance is to cover financial upset in the event that the bread winner in the household loses their life. It is a sad subject to think about, but an important one. What is your family to do if they no longer have the income that you provide? Are they going to lose the house because they can no longer pay the mortgage? Will they be able to pay the bills, or even cover the cost of a funeral? So, you know you need it, but how does term life insurance work?

One Possible Term Life Insurance Scenario
Let's take a look at a hypothetical situation to best explain how it works. Mike is a 35 year old male who doesn't smoke, is in good health, enjoys outdoor activities like hiking and has just married Michelle who has a 6 year old daughter named Rachel. After the wedding, they take out a mortgage on their first home and move in. Michelle works part time, but Mike works full time and is the main source of this new family's income. Things have been going well for a few years until Mike is on his way home from work and is killed in a car accident. The sadness is inexorable and fear from Michelle abounds as to what she is going to do financially to take care of Rachel, the house and herself as well as Mike's funeral.

Luckily, Mike took out a term life insurance policy. He had spoken with an agent recommended by a co-worker and after discussing several types of life insurance, he bought a term life insurance policy that fit his needs and was least expensive for the amount of protection it provided. Here's what he discussed with the agent.

How Much Coverage Do I Need?
A simple rule of thumb is to take your annual salary and multiply it by 10, but for a more direct approach other things should be considered. In Mike's case, he has a house worth $250,000, credit card debt in the amount of $20,000, he now has a daughter who wants to go to college which will be at least $50,000 and to keep up the house and pay the bills it costs about $7000 a year. Once you add in the potential cost of a funeral, you get $337,000. So, if you add on another 15% of that to cover unforeseeable expenses, you get an appropriate insurable amount of $387,550. The agent decides to round that up to $400,000 and comes up with a $580 premium that Mike has to pay every year.

How Long Should My "Term" Be?
The whole idea behind term life insurance is its time limit. You can have a policy that is renewed annually which is good for people who might have a little bit of debt that will be passed onto loved ones. Once the debt is paid off, you're not stuck with paying for life insurance that you don't need. In Mike's case however, he decides to take out a 20 year policy. Hopefully by the end of that 20 year term, he will have paid off his debt, paid for Rachel to go to college, no longer has a mortgage and will no longer need a policy with such a large amount.

Now, since Mike died within that 20 year term, Michelle and Rachel who he named as his beneficiaries received a pay out from the insurer in the amount of $400,000. Used wisely, this amount of money can be used to cover the next 20 years or more of living expenses that Michelle and Rachel will encounter.