Most people, when they think of life insurance, don’t picture a policy with cash values, investments, and so forth. They envision life insurance simply as straight forward as paying premiums in exchange for a death benefit when they die. This is exactly the principle of term life insurance. As part of a series of posts covering the basics of life insurance, in this week’s topic I will cover the 5 most common uses of term life insurance.
1. Pay off final expenses
When a person dies, his family is grief-stricken from the emotional loss. The last thing they want to deal with is final expenses as a result of the death. Such expenses include burial costs, final medical bills, probate costs, lawyer’s and executor’s fees, and the final tax return. While providing for this can be accomplished with permanent life insurance, proceeds from a term policy can also be used to pay for these expenses.
2. Provide for specific family needs
How the death benefit is used depends on the family and their specific needs. Some may select a death benefit that matches the mortgage on the home, so the spouse does not have the burden of monthly mortgage payments. This is the premise of mortgage insurance offered by mortgage lenders. But beware, there are many major differences between mortgage insurance offered by mortgage lenders and an individual term life insurance policy that the mortgage lender would rather you not know. But that is another post for another time.
Besides mortgages, term life insurance is also effective for paying off other debts. Many people have student loans, car loans, credit card debt and other loans that can add up to hundreds of thousands of dollars. The burden of these loans on a family can be catastrophic if the primary income earner passes away prematurely.
Another specific family need may be to provide for an education fund for the children. With the cost of post-secondary education in Canada rising at 3 times the rate of inflation, by the time high school graduation arrives, you may be looking at the cost of a degree of well over $50,000.
Since these needs are usually most necessary during working years, term life insurance is appropriate because it can be acquired at a lower initial premium than permanent insurance and cancelled when the specific family need is fulfilled.
3. Income replacement
One of the things a family will miss the most with the death of an income earner is the biweekly pay cheque. After all, bills still need to be paid and food still needs to be put on the table after the death of an income earner. Term life insurance can be used to alleviate the financial loss. The policy is taken out on the income earner of the family to provide for his family in case of death during his prime working years. This often involves a calculation with figures such as the annual income, number of years until retirement and inflation to reach a conclusion on how much death benefit is required. This method ensures the least alteration in lifestyle.
A simpler way of calculating income need is to use a multiplier, such as 5x or 10x the annual income. The larger the multiplier, the more money there is for the survivors. Couples with young children should opt for a larger multiplier, such as 10-15x. When the children have grown up and become independent, you can lower this to 5-10x.
4. Business applications
Term life insurance can be used to fund buy-sell agreements so that on the death of a business owner, surviving partners can use the proceeds to purchase the business from the deceased owner’s beneficiaries. This is especially important because the beneficiaries are often family members not involved in the business. Term life insurance allows the surviving partner to buy the shares from the family members of his deceased partner, who want no part of the business and will be happy to be bought out.
Term insurance can also be used to insure a key person in the company so that business can continue smoothly after the key person’s death. It can help the company hire and train a new employee, ease lenders’ concerns about your company’s financial health, and pay off debts.
5. Temporary need converted to permanent protection
The last most common use of term life insurance is conversion. That is, foreseeing a future permanent need while also having a temporary need for life insurance. For example, the temporary need may be to provide for the family, with the permanent need being to leave a legacy to family members in retirement. The convertible term life insurance option provides a low initial cost for a young family while the converted permanent life insurance will hopefully be funded by a much larger bank account during retirement.
As you can see, there are many different uses of term life insurance. Click here for more information about the basics of term insurance.
Image courtesy of ddpavumba / FreeDigitalPhotos.net
