When you buy insurance, do you pay attention to words such as “premium,” “deductible” and “term”?  You should, because these funny-sounding words are the nuts and bolts of how insurance works, and knowing how to manage them well can save you a lot of money.

Good insurance is an important part of sound financial planning. It removes some of the financial risk that comes from living in an unpredictable world, and it allows us to plan in advance for emergencies that would otherwise be difficult to prepare or account for. But not all insurance is created equal — in fact, no two policies are exactly alike. In order to get the insurance policy that meets your needs and your budget, you need to have a firm understanding of some of the key ingredients of insurance: premiums, deductibles and terms.

Here’s a quick overview of each of these ideas, as well as some tips about how to balance them to create insurance that serves you well.

Premiums

In the simplest terms, a “premium” is simply the price that you pay for insurance. The way that you pay can vary greatly from policy to policy: Some things, like auto or homeowners insurance, are priced in six-month intervals. Other things, such as health and life insurance, are often priced on monthly plans. No matter how the price is presented, though, you should be able to pay any kind of insurance on a monthly basis.

The important thing to understand about insurance premiums is that they can vary widely, depending on the kind of policy that you have. Unlike a gallon of milk, which costs roughly the same amount in stores all over town, the premiums on insuring your car, life or home are going to be calculated on a bunch of risk factors, as well as important elements such as term and deductible. The higher the value of the item you want to insure, the more your premiums will be. Premiums also get higher as terms get longer. More on that later.

Deductibles

Deductibles are one of the most interesting concepts in insurance. A deductible is the amount of money that you have to pay to fix something before your insurance coverage kicks in.

Here’s how it works: Let’s say that you want to insure a car worth $10,000. Your insurance company will want you to take some of the financial responsibility if you wreck the car; the amount of responsibility you take is largely up to you. The value of that responsibility is represented in your deductible. If you chose a deductible of $1,000 and then you total the car, the insurance company is going to cut you a check for $9,000. You’re responsible for other $1,000. If you have a small incident that only costs $1,000 to repair (minor body work, for example), that charge falls entirely to you. Insurance doesn’t pay anything until you have paid the entire amount of the deductible out of your pocket.

Here’s the important thing about deductibles: They’re flexible, and the amount of your deductible is closely related to the amount of your premium. The higher your deductible (the more responsibility you take for yourself), the lower your premium. An auto policy with a $2,500 deductible is pretty cheap, while a policy with a $500 deductible or less is going to be more expensive.

To make the most of insurance, you need to balance your deductible with your savings. If you don’t have much of an emergency fund saved up, you need to have a low deductible so that one disaster doesn’t ruin you financially. If, on the other hand, you have plenty of money in savings, you can afford to set a high deductible on your insurance policies. This brings your monthly cost of insurance down, and can save you a lot of money in the long run.

By the way, the term “deductible” is most often used in home and auto insurance. In health insurance, you’re more likely to see the terms “co-pay” or “co-insurance,” but they’re basically the same thing as a deductible. The idea of a deductible is not applicable to life insurance.

Term

In insurance, “term” means basically what it sounds like — a term is the length of time that a policy is in effect. In auto insurance, terms are often six months, while many homeowners insurance policies have 12-month terms.

What this means is that when you buy a policy, it’s technically only applies during the length of the term. If your term expired and for some reason you didn’t renew, you would be completely unprotected from events that happened after the insurance expired. Thankfully, most home and auto policies are set up to renew automatically. As long as you’re current on your premiums,, you shouldn’t have to worry about your term expiring.

Terms become much more important when we talk about life insurance. Life insurance is set up to pay your survivors a set amount of money if you die. Life insurance is set up according to terms: You can insure your life for 10, 20 or 30 years, for example. If you die within the term of the policy, your family receives a full payout. If the term expires, however, you lose your protection.

The term of the life insurance policy you choose will have a big impact on your premium. The chance that you’ll die sometime within the next 30 years is much greater than the chance that you’ll die within the next 10 years. That makes it much more expensive to buy 30-year term insurance than to buy 10-year term insurance. Of course, there are more factors to this, and we’ll dig into more detail on a future article about life insurance. But the important thing to remember here is to pay attention to the term of the policy that you’re buying, and make sure that it fits well with your budget. And whatever you do, don’t go unprotected when your term expires.

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Photo by Greeblie. Used under Creative Commons License.