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Life insurance is one way to provide financial protection for your family and loved ones. Your monthly or yearly premiums bring peace of mind, because you know your family will be financially secure if you die.
The two main types of life insurance are term and permanent (cash value). Term insurance covers you for a specific period and delivers the coverage amount to your beneficiaries if you die before the term expires. Permanent insurance covers you for your lifetime and pays when you die, no matter when that happens. Both types of insurance require timely premium payments to maintain coverage.
Term vs. permanent life insurance: key differences
Term life insurance is simple and easy to understand. Some companies, such as Fabric Life Insurane by Gerber, sell only term policies based on both the simplicity and economy of this type of coverage. With term, you pay so much a month for so many years and are covered for a specific amount for that time period. It’s uncomplicated, effective, and economical.
Permanent life insurance, on the other hand, combines term insurance with an investment option, making it more expensive and more complicated. This is because part of your premium pays for term insurance and part is invested to provide potential future wealth or premium support.
|Term Life Insurance||Permanent Life Insurance|
Typically five to 30 years
Access to funds
No cash value to access
Cash value accumulates and can be borrowed or withdrawn
Up to $3 million
Up to $1 million
*For a healthy 30-year-old male buying a 30-year, $500,000 policy – Source: aven Life by Mass Mutual.
What is term life insurance?
Term insurance is a life insurance policy that provides coverage for a specified time, typically five to 30 years. With this type of insurance you pay a monthly or annual premium. If you die before the term expires, the insurance company pays the death benefit to your beneficiaries.
Term insurance has no cash value. Your premiums only pay for insurance during the life of the policy. This typically makes term insurance less expensive than permanent life insurance. Term life insurance is usually available in several different configurations, which in some cases can be combined.
There are several types of term life insurance.
A level term policy pays the same benefit amount if you die at any point during the term. Typically, level term charges the same premium for the policy's life and is calculated at the beginning of the term based on your current age and health. Level term policies may require a medical exam.
Decreasing term life insurance also has a set coverage period, but the benefit drops over the policy's life. Decreasing term covers a debt (such as a mortgage) that decreases over time. Premiums remain the same for the term of the insurance and take into account the fact that the payout will decrease. Ladder Life, for example, offers adjustable coverage, up or down, as needs change, utilizing a digital platform.
A renewable policy continues for an additional term (or terms) up to a specified age, usually 80. With each renewal—five, 10, 15, or 20 years—the premium increases based on your age at that time.
Renewable term guarantees that you can renew the policy even if your health would cause rejection if applying for a new policy. It allows for the flexibility of term insurance while providing continuity, just like permanent insurance.
Return of premium (ROP)
Term insurance, by definition, includes coverage for a set period with no savings or investment. One exception is called “return of premium (ROP)” insurance. With this type of insurance, if you live to the end of the term, you get back all or most of the premiums you have paid. While this sounds like a good deal, there is a cost. First, the premiums are significantly higher than with regular term insurance. You must keep the policy in force until the end of the term, and you only get back the premiums you paid; you don’t earn any interest or dividends on those premiums.
Term life insurance pros and cons
There are several advantages and disadvantages of term insurance, driven chiefly by your circumstances and insurance needs.
- Affordable premiums. Term insurance is the most budget-friendly insurance available, making it a good fit for people who need maximum coverage at minimum cost.
- Coverage for a specified period. If your insurance needs have a time horizon—such as until you pay off your mortgage or your children are on their own—term insurance is ideal.
- Straightforward and easy to understand. Term insurance is simple. It insures the policyholder for a specific period and pays only if the policyholder dies during that period. There are no cash value, loan, or complicated contract provisions.
- No cash value. Term insurance is just that: insurance. Your premiums do not go into savings or investments; at the end of the term there is no balance.
- Premiums can increase at renewal. Permanent insurance premiums stay the same for life, while term insurance premiums can increase at policy renewal.
- Not as flexible as permanent insurance. The simplicity of term insurance can also be a problem for those who need the flexibility of permanent insurance, including savings.
What is permanent life insurance?
Permanent life insurance lasts until you die, as long as you pay the premiums. Unlike term insurance, permanent life insurance policies accumulate cash value over time, which can be used as a source of savings to pay future premiums or borrowed against and repaid.
Permanent life insurance policies are more expensive than term insurance policies. They can be more complicated, as they contain savings or investment options and other features not commonly found in term life insurance policies. While there are many variations in permanent life insurance, four types make up the majority of policies.
Whole or ordinary life
This is the most common type of permanent life insurance, and it offers both insurance and savings. Part of your premium pays for insurance, and the balance goes into a savings account that pays dividends and grows over the years. You can withdraw from your savings or borrow (and pay back) funds. Everyday Life, which offers term policies with up to $2 million coverage, also provides whole life insurance for people up to age 85, and says 90% of applicants never have to take a medical exam.
Universal or adjustable life
This type of policy is more flexible than whole life. For example, you may increase the death benefit if you take and pass a medical exam. The savings part of this type of policy usually earns an interest rate equivalent to that of a money market account. You can lower your premium payments if you have enough savings to cover the cost. However, if you use up your savings, your policy may lapse.
A variable life policy combines insurance with a savings account that you can invest in stocks, bonds, and money market mutual funds. This type of savings is riskier than a guaranteed interest rate, but it can grow more quickly. If your investments do not do well, your death benefit and cash value may decrease. Some variable life policies guarantee that your death benefit will not fall below a certain level.
This hybrid policy combines variable and universal life features. The investment side carries risks and rewards similar to variable life, and the life insurance side lets you adjust your death benefit and premiums like universal life.
Permanent life insurance pros and cons
The pros and cons of permanent life insurance reflect the primary differences between permanent and term policies.
- Lifetime coverage. This type of insurance covers your lifetime, providing you keep up with premium payments.
- Cash value. Permanent life insurance can accumulate cash value over time.
- Flexibility. The cash value can be used as a source of savings, to pay for future premiums, or as collateral to back up a repayable loan.
- Expensive. Permanent life insurance policies tend to be more expensive than term policies.
- Complicated. This type of policy can be more complex and challenging to understand than straightforward term insurance.
- Cancellation fees may apply. Your contract may contain cancellation fees or loss of interest. Read the agreement carefully before you sign up.
When is term life insurance the right choice?
Term insurance is best if you need coverage for a specific period, including covering mortgage payments for your beneficiaries, providing college tuition or other financial support, or until your retirement nest egg can take on your financial burdens. Another excellent use for term insurance is for final expenses. Although burial insurance exists, some companies such as Ethos Life, recommend one of their low-coverage term or whole life policies for this type of coverage.
As term insurance tends to be less expensive than permanent life insurance, it is the best option for those with limited resources but significant financial responsibilities. While it doesn’t offer cash value or loan options, it provides the one thing most people need, especially early in their careers and lives: insurance against catastrophic loss of income.
When is permanent life insurance the right choice?
Permanent life insurance makes the most sense if you know you want coverage for your entire lifetime, not just a set period. It can also be a good choice if you want to build cash value and create an inheritance for your loved ones or a favorite charity while paying a set premium.
It’s essential to weigh these factors against the higher cost of permanent life insurance and the difficulty of canceling a policy if circumstances change. For those who want a set amount of coverage over their entire lifetime and want to know how much it will cost them in advance, permanent life insurance is the way to go.
Alternatives to term and permanent life insurance
Although life insurance is the first thing most people consider when contemplating financial protection for loved ones, it’s not the only way to provide that protection.
Whether you have life insurance or other assets to pass on, you should have a will. A will is a legal document that explains how your assets will be distributed after you pass away. You can name beneficiaries and assign them specific assets or percentages of your estate.
A trust is a legal entity that distributes your accumulated wealth to your heirs, much like a will, after you die. There are many different types of trusts, including revocable, irrevocable, living, and testamentary. The primary advantages of a trust over a will are potential tax benefits and better control over how the trust distributes your assets.
One creative way to distribute your assets would be to form a family bank as a legal entity that enables family members to borrow money at a low (or no) interest rate. They would have to pay the money back, making their inheritance self-perpetuating.
Inheritable Roth IRA
Instead of purchasing insurance, you could put your money into an inheritable Roth individual retirement account (IRA) with designated beneficiaries. The funds continue to grow tax free and may be withdrawn tax free. You could convert a traditional IRA to a Roth to avoid saddling your heirs with taxes upon withdrawal. You could do the same with a traditional 401(k) account. In both those cases, you’d need to pay taxes on the funds you convert.
Another option, similar to an inheritable IRA, is an annuity. The advantage is that the annuity could be a lump sum or an income stream for the beneficiary's life. The younger the beneficiary, the more valuable an annuity could be. Of course, though, its cash value lessens as inflation rises.
As simple as it sounds, self insurance means your personal wealth and assets are sufficient to provide for your loved ones after you die. Funds for self insurance could come from savings, investments, even an inheritance you received. Self insurance may also be appropriate if you are debt free and have no dependents.
This tactic could include rental properties, a vacation home, or other types of property. You would want to set up a family limited partnership or trust to make transferring the property easier after you die.
TIME Stamp: Term insurance provides maximum protection at minimum cost
When it comes to bang for your buck, it’s no contest. Term life insurance provides the most coverage for the least amount of money. If you want to guarantee your loved ones will be taken care of if you die before you have accumulated enough wealth to do that on your own, term insurance is an inexpensive, easy-to-understand way of achieving your goal.
This does not mean permanent life insurance, in all its permutations, is a wrong choice. If you want to provide protection and build an inheritance by paying a fixed monthly sum for life, permanent life insurance is certainly one way to get there. And, as with term insurance, the proceeds are distributed tax free.
Frequently asked questions (FAQs)
How much life insurance do I need?
You need enough life insurance to equal 10 to 12 times your annual income, according to most experts. Your final figure should take into account other sources of income and assets, such as real estate or valuables, that may alter that figure. The best way to determine how much life insurance you need is to consult with a trusted financial professional. Keep in mind that the coverage you need may change over time, so reassessment on a regular basis is important.
What happens at the end of term life insurance?
Coverage expires at the end of a term life insurance policy. To provide continuing protection for your loved ones, you must renew or take out another policy. Some term policies offer renewal, and some even offer conversion to permanent life insurance if you want to do that. Read your policy carefully before signing up, so that you know your options.
Can you have both term and permanent life insurance at the same time?
Yes. There is no law against simultaneously having a term policy and a permanent life policy. This combination may be desirable in some cases, as it can provide additional short-term coverage at a low cost when you need it most, plus a long-term policy for later in life. As with all life insurance, consult a trusted financial advisor to ensure that this strategy makes sense.
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