Life Insurance: Super Simple Guide
Life insurance is one of those financial products everybody knows about but not everybody has grasped the basics. And it’s not a big problem as long as you do the research before talking to salespeople. If you don’t, you’ll get pitches all over the place.
So, get your basics right. And this post is on them THA basics.
#1 What is life insurance?
It’s a contract. It stipulates that you agree to make certain payments to an insurance company during the term of the contract, while the insurance company agrees to pay out a certain amount to the beneficiaries in the event that you pass away. An insurance policy is a fancy-pants for “insurance contract”.
The amounts you pay are pretty small. For example, $30 per month.
While the amount your beneficiaries will receive is much bigger than those payments, Say, $500,000.
The insurance company collects the payments from all of its customers within a certain cohort. Then it pays out the amounts to those families where the insured risk has realized, i.e. where the insured person has passed away.
It’s an instrument you use in order to buy the peace of mind that your beneficiaries’ financial needs will be covered in case you die.
It’s completely up to you who you name as the beneficiaries. But, as a rule, people take out life insurances when they want to cover their dependents against the loss of income they will experience in case of their death. The dude next door — not a beneficiary. Your kid — beneficiary.
#2 Can life insurance be something else?
Yeap. Lots of things. Lots of insurers take the basic concept of the life insurance policy, smack something else on top and market it as an “innovating and cutting-edge life-changer”.
So, why don’t we like it?
The problem is that insurers should deal insurance. Other smackable stuff… you should buy it from duly qualified and certified folks. I.e., if you want to invest, buy stamps or stocks. Don’t buy insurance + investment asset.
If you visit a dentist, you might not necessarily want to buy into the real estate project he’s pitching you with your mouth wide open. You’ll smile, nod tentatively and say something “Yyyyyeeeeeahhhhsssshhhh, ohhhhheeeey”. Would you go in on it. I don’t think so.
After you’ve read this bare-knuckle basics guide, make sure that you just pass on anything smakable… Don’t listen to anybody. You are shopping for life insurance. So, buy the life insurance, don’t buy your dentist’s yacht.
#3 Why type of life insurance do I need?
There are two major classes of life insurance policies — term and whole life. It’s amazing that some folks still continue pitching the whole policies, while if you poll NSA financial analysts and bloggers, 90% of them say that the term is the best option and I don’t know why 10% would stray. Here’s a great research showing just that.
Let’s compare the two briskly.
The term policy stipulates the following:
1) You need to pay a monthly premium to the insurance company ($30)
2) You can select one of the term periods for the policy. This can be 5, 10, 20, 30 years.
3) As long as you make the monthly payments, the policy remains in force. And if you stop making the payments, it’s terminated.
4) Should you pass away within the policy’s term, your beneficiaries will receive the payout.
5) At the end of the contract’s term, the policy is terminated and nothing else happens.
The whole policy stipulates the following:
1) You need to pay a monthly premium to the insurance company (much more than $30 since the insurer agrees to cover you throughout your life, for instance $300. Think 10x.)
2) There is no term since it the “whole life” insurance.
3) As long as you make the monthly payments, the policy remains in force. And if you stop making the payments, it’s terminated. (I don’t even want to talk about your ability to borrow against the equality you would have accumulated because it’s all would-have’s. It’s not solid.)
4) Your beneficiaries will receive the payments upon your death.
As you can see, the monthly payments for the whole life insurance are around 10 times higher. And, let’s make it clear, if you make 2K per month, you are 30 and have 1 kid… $300/mo gonna sting (meaning, you aren’t gonna do it.)
But, you might retort with “But it’s the whole life! It has limits. That’s why I need to shell out $300”. The underlying question here is “Do you actually need to have the coverage throughout your life?”. Read on to get the scoop on the point.
#4 What term do you need to stipulate? And maybe you should actually go the “whole life” (if you do, the term will be “throughout your life”?
If you go back to #1, you’ll see that the life insurance is a tool to buy the peace of mind.
A peace of mind regarding what? What are we trying to hedge against?
And this is the correct question.
Let’s example.
Example: You have two kids ages 2 and 5. You are the sole breadwinner. You expect your spouse might want get back to work within 3 years. You have zero debts. You have the mortgage for $300K. You live in the mortgage. You have no other steams of income.
Here’s what you can do:
1) Define the numbers of years you would want your family to get covered in case of your demise. For instance, you decide that you want to cover your kids till both of them are 18 (since your youngest is 2, this means 16 years).
2) And that’s it. There’s nothing else to do here. It’s that simple.
Now that we know the actual terms for which you need to obtain the coverage, let’s compare the two types of insurance policies again.
With the term policy, you’ll be able to take out the 20-year policy (since you need to cover the next 18 years) and you’ll be paying, say, $30 per month. At the end of the 20-year period, the policy will just terminate. And you’ll be OK with that since there’ll be no dependents for you to cover anymore.
With the whole policy, you’ll have to pay 10x. Say, $300. And you’ll need to pay the dough month in and month out. Even after the 20-year period has ended and you — kinda — don’t need to cover your dependents since there are no dependents anymore, you will still continue making the monthly payments.
So, as you can see, the whole life insurance is… well… it’s for those people who have very large asset bases and income sources. You know what I am saying. The 1%. And I am not sure that it makes sense to buy any kind of life insurance in those cases anyway… But, for us, middle class, the term is the best. And salespeople have a hard time selling the whole life (I wonder why). So, whenever they pull off one, they get super-fat fees. Like the first year of your payments is going to their pockets. That fat.
Now, let’s get back to math. All those data from that example above. We need to make use of it! (And, yes, you should consider becoming an insurance agent.)
#5 How much term insurance should you buy?
At this point, I expect that you have the pristine clarity. You see that you need the life insurance. You understand that the whole whole insurance is fishy. You understand that the term is 20Y, dah.
But what about the payout amount? How much should it be?
Here’s that example again — You have two kids ages 2,5 and 5,5. You are the sole breadwinner. You’ve bought Wii. You play tennis with your fam. You expect your spouse might want to go back to work within 3 years. You have zero debts. You have the mortgage for $300K. You live in the mortgage. You have no other steams of income.
So, let’s determine the amount of coverage you might want to get:
1) Loss of income:
i. Define your annual salary. Now salary. Not when that Mars colony goes big. Say, $50K.
ii. Multiply the annual salary by the number of years you want to get. So, 20Y x $50K = $1M
2) Debts and big liabilities:
$0 for debts + $300K for mortgage = $300K
3) Other assets:
Get super-conservative here. Don’t account for anything else in order to conservative out anything.
Don’t account for i) income you spouse will make, ii) profits from selling space potatoes, iii) anything even less credible
So, other sources of income = big fat $0
Total: $1M + $300K + $0 = $1,3
That’s the amount of coverage you want.
Nifty, right? Do you want to see the actuary table I used to arrive to the number? There’s no actuary table. Just math and two-level numbered lists.
#6 When should you buy the life insurance policy?
As soon as possible. It’ll add up around $30-$60 to your bills. Not much, but.
But it’ll give you the peace of mind you are seeking for. And life insurance is the product that brings you the peace of mind. It’s not an investment vehicle or anything else. It’s not.
The younger you are, the less the premiums will be. So, if you take out the 30-years policy when you are 30 and in good health, you’ll fix good premium rates. And make sure that you don’t actually get a flexible-rates contract.
And you can always just terminate the policy at any time. There’s no lock-in, there are no forfeiture fees or something like that.
#7 How to find a good offering?
Just browse through the offerings at AccuQuote, FindMyInsurance, or LifeInsure. You have all the inputs to compare the offers and start picking the winners.
For a more in-depth look at the life insurance universe, read this mega-guide. It does have all the answers to all the questions.
And that’s it. Now you know what the life insurance is, what type is best for ya, what term and what coverage you need. And, most importantly, you know how you got here!
