Life insurance explained: what it is and how it works for beginners

Life insurance can help provide a financial benefit to the people you leave behind if you die. It is often a practical choice for parents, partners, primary earners, homeowners and others whose dependents rely on their income to manage day-to-day expenses.

That said, life insurance is not suitable for everyone or every budget. Before buying a policy, it helps to understand the basics, including how coverage works and what it may cost.

What is life insurance?

Life insurance is a policy that pays money to your family members, relatives or other designated people after your death. You choose one or more beneficiaries, pay premiums, and if you die while the policy is active, those beneficiaries can file a claim and receive a death benefit based on the coverage amount.

Applying for coverage usually involves answering health questions and, in some cases, taking a medical exam. Some insurers also offer no-exam policies for people who prefer not to complete one or are concerned about the results. Pricing depends on several factors, including the insured person's age, health, policy length, coverage amount and other details.

Types of life insurance

There are three main kinds of life insurance policies:

Term life insurance

Term life insurance provides coverage for a set period of time. Depending on the insurer, terms can last 30 years or longer, and many people use this coverage for specific obligations such as a mortgage or a child's college expenses. It generally costs less than whole life or universal life insurance.

Whole life insurance

Whole life insurance is a type of permanent coverage designed to last for the policyholder's entire life. These policies also build cash value over time through a guaranteed interest rate, although that value takes time to accumulate before it can be accessed. Once enough cash value has built up, money may be withdrawn from the policy.

Universal life insurance

Universal life insurance is another form of permanent coverage that also lasts for life, but it offers more flexibility than whole life insurance. With this type of policy, you may be able to change the death benefit and use policy value to help lower premiums. Depending on the policy, cash value may grow based on declared rates or market-linked formulas. Policyholders need to keep an eye on funding and policy charges, since too little cash value can cause the policy to lapse.

What does life insurance cover?

Life insurance can help pay for funeral and burial costs, lost income, unpaid debts, medical bills and other expenses left behind after a person's death. However, it only pays out if the death occurs for a covered reason.

Common covered causes include natural causes, accidents and terminal illnesses. Policies often exclude deaths related to the following:

• Acts of war

• Suicide after a certain waiting period

• Participation in dangerous activities

• Committing a crime

• Fraud during the application process

Before buying a policy, be sure to review the exclusions carefully so you and your beneficiaries understand the limits of the coverage.

How much does life insurance cost?

The price of life insurance depends on factors such as age, health, gender, policy length, policy type and coverage amount. Men generally pay more than women, and premiums tend to rise as the policyholder gets older.

Below is a look at estimated term life insurance costs for a 35-year-old in average health, with no history of nicotine use, living in Houston, Texas, according to Ethos.

These figures are only rough estimates. Your actual premium will depend on your health, the policy you choose and your individual needs.

How much life insurance do you need?

There are several ways to estimate how much coverage to buy.

Common approaches include:

• 10x income: Multiply your annual salary by 10. That amount is often considered a minimum starting point. If you have children, you can add $100,000 per child for future education costs.

• DIME: Add up your household debts, income, mortgage balance and education costs. The total gives you a sense of how much life insurance may be needed.

• Obligations minus assets: Tally your financial obligations, such as your mortgage, future college costs, yearly earnings, car loans and other debts, then subtract your liquid assets, including savings and college funds. The remainder is the amount to cover with life insurance.

• Income before retirement: Another method is to estimate how much income your dependents would need until your retirement age. Multiply your remaining working years by your current annual salary.

In general, you should think about your age, number of dependents, debts held by you or your spouse, your income and any inheritance plans for your children or other loved ones.

If you're unsure how much coverage you need or which policy type fits your situation, consider speaking with a financial professional. Ideally, choose someone independent and not tied to a particular insurance company so the advice is as unbiased as possible.