What Is Term Life Insurance?

by Neal Frankle, CFP ®

When you ask, “What is term life insurance?” the answer is simple. Term life insurance is just a tool. But it’s a very specific tool and it’s important to understand how to use it correctly.

Term life insurance is a tool that you rent as long as you need it. You never “own” it. I’ll explain that in just a bit. First let’s look at the main benefits of owning term life insurance.

 

 

First, term life insurance replaces your income (in case you die) with a lump sum payment to your survivors. Your survivors take that lump sum, invest it and earn income from those investments. That income replaces your income (which you can’t earn anymore because you’re dead).

The assumption is that the lump sum will be large enough so that, when invested, it creates enough income for the family. When you buy term life, you should do that calculation first to know how much life insurance you need.

Let me give you an example. Let’s say you earn $75,000 a year and your family spends that income. You need to make sure your family has that income in the future – even if you aren’t around to earn it. The question then becomes, how much term life insurance do you need?

A very rough rule of thumb is to figure that you could make 5% on your money. So, if you need to earn $75,000 from the insurance proceeds, the question becomes, how much do you need to invest to earn $75,000 if you could earn 5%? (By the way, this also tells you how much money you need to retire.) To keep things simple, we’ll ignore inflation here and deal with that in another post.

All you have to do is divide $75,000 by 5% to get your answer. In this case, it works out to be $1,500,000. If we assume you have no other investments or income, that’s how much term life insurance you’d need to have.

How long will you need that insurance for?

Using the example above, let’s assume that you’ve done your homework. You figure that if you bring home $75,000 each year, you’ll be able to save enough (after your spending) to retire after 20 years. That means you won’t have to work or get a second job in 20 years. And that means you won’t need insurance after 20 years.

In other words, you “rent” the insurance until you have enough money saved. You have saved “enough money” when your savings are sufficiently large enough to create the income you need.

Think about the example above. If you had $1.5 million now, you wouldn’t need the insurance even if you plan on working for another 20 years. That’s because your family only needs $75,000 a year and you already have enough ($1.5 million) to generate that income.

In summary, term life insurance is a great tool if you use it wisely. It’ll save you a ton of money (compared to whole life) and it will provide security for your family.

Did you do a calculation like this to determine how much life insurance you need? If not, how did you run your calculations?

 

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