One of the most important financial decisions you will ever have to make is deciding how much life insurance you need to buy. Life insurance helps provide for the security of those you will leave behind in the event of an untimely death. The question is, however: how much? Too little coverage might end up making your family poorer after you’re gone because it won’t be enough to protect them. Too much could be inflationary because the premium required to maintain that coverage becomes unnecessarily high.
This step-by-step guide will help you know how much you really need in your life insurance while walking you through the key considerations, calculations, and approaches you can take. Thus, by the end, you should be clear about what determines your insurance needs and how to make an informed judgment.
Step 1: Understand the Purpose of Life Insurance
But before diving into numbers, let’s first talk about what life insurance is. Simply put, life insurance is a benefit paid by the company to your dependents-the spouse, children, or any other family member-if you were to die. There are several uses of proceeds from a life insurance policy that include:
- Replenishing the income lost
- Payment for outstanding debts such as mortgages and credit cards, as well as student loans
- Burial or funeral costs
- Costs of the children’s education
- To help your family keep their standard of living as it is today
- To leave behind an inheritance
- Knowing how life insurance serves your purpose will help to estimate how much coverage you will need.
Step 2: Calculating Your Life Insurance Needs
First, in calculating your life insurance needs, you have to assess the present and future obligations that you have. The concept is to ensure that the dear ones can meet those obligations if you are no longer around. Here are the major financial obligations that you should consider:
A. Income Replacement
If you are the primary breadwinner or earn the bulk of the household income, you will want to construct a life insurance policy that can replace your income for some number of years. This is to enable your family’s continued lifestyle of living and necessary expenses if something were to happen to you (shelter, food, healthcare, utilities).
How to Determine Income Replacement
First of all, calculate your current annual income; that is, your salary, bonuses, commissions, etc.
Calculate how many years it would take your family to replace you, using a generally accepted rule of thumb of the equivalent of $10-15 years’ worth of replacement income.
Consider the effects of inflation. Because living expenses are sure to increase, you may want to factor in some sort of inflation so the death benefit will be adequate in the future.
For example, if you have $50,000 yearly income, and you wish to pay off the income in case you die within 10 years, you ought to have at least $500,000 or more on life insurance.
Debts and Liabilities
When you die, your debts do not automatically disappear. Your family will probably be forced to face them. Life insurance may provide to pay for outstanding debts, so your loved ones are not left behind with this burden of the financial debt.
Common debts to consider :
- Mortgage: Get the remaining amount for your mortgage and ensure the amount of your policy is at least that.
- Auto loans: Sum in the outstanding balances of any auto loans you may be carrying
- Student loans: Do you have outstanding student loans, especially private loans? These usually are not forgiven if you die.
- Credit card debt: Add up all the outstanding balances you carry on credit cards today.
Add these amounts together to come up with an estimate of the amount of life insurance you’d need to pay off your liabilities.
Education Expenses
If you have kids you want to make sure to fund their education in the event they need to attend college. Education expenses can be very high, and therefore, life insurance can ensure that there will be enough money for higher education to continue in the event either or both parents is not around.
How to Estimate Education Expenses:
- Count the number of children you have and their ages at this time.
- Look over a ballpark estimate of what they will cost in terms of tuition, room and board, and other standard expenses. Your costs should be much different as between public and private colleges.
- Calculate for inflation. College costs increase each year, so be sure to anticipate that you could see more increases.
For instance, if you have estimated that the college will cost $50,000 a year and you have two children whom you expect to take four years each, you would then add $400,000 to your life insurance coverage.
D. Final Expenses
Funeral and burial expenses can be a pretty heavy burden, with some costing between $7,000 to $15,000 or more. Adding a final expenses rider to your life insurance will save your family from shelling out on such costs.
Step 3: Your Assets and Savings
While determining how much life insurance you need, you will also want to consider how much available financial resources your family will have at their disposal when the payout from your life insurance is deducted. These resources help decrease the quantity of coverage necessary. Some common ones are:
Savings and investments: This would include your money savings, retirement accounts, 401(k), IRAs, brokerage accounts, and any other forms of investments. These assets can be liquidated to pay off different kinds of debts when you pass away.
Real Estate: If you have real estate, consider including its value in the overall aggregate, but if there is any possibility that your family might need to sell the property for access to these funds, then do not include their value.
Other group life insurance: If you have already coverage via an employer or another company, count those dollars in your overall death benefit.
Minus your assets from your liabilities as subtracted to come up with a better idea on how much insurance you need to fill the gap.
Step 4: Choose a Coverage Strategy
There are different ways you can approach the calculation of your needs for life insurance, and each method has its pros and cons. Depending on your goals, you may apply one or a combination of these methods.
A. The DIME Method
The DIME method is one method that simply estimates how much life insurance you might need, focusing on Debt, Income, Mortgage, and Education, by summing the following
- Debt: Total debt outstanding (not your mortgage)
- Income: Number of years income replaced (typically 10-15)
- Mortgage: Outstanding balance on your mortgage
- Education: Future education expenses for your children
By adding all of these numbers together you can create an estimate of the life insurance coverage you will require. Although this formula is simple to use, it will not account for the many other variables in your individual financial circumstance.
B. The Human Life Value (HLV) Approach
The Human Life Value approach is even more central to determining the value of your life, in terms of the future income you will earn. Among these are:
Determine your future income: What you make now and what you anticipate earning during the balance of your work life.
Subtract taxes and personal expenses: Your family will not require your entire income. Subtract taxes, retirement savings, and the amount you spend on personal expenses, like hobbies and dining out.
Account for inflation: Expand future earnings by inflation to stay current with increased costs of living.
The HLV method is supposed to replace your total financial input toward the well-being of your family during your lifetime. However, it may result in higher cover than is needed, especially in the event that your family has other financial inputs.
C. The Needs-Based Method
This approach, called the needs-based method, determines just how much a family would need financially in the event of a death within the family unit. The approach involves identifying definite financial obligations like debts, income replacement, education cost, and the amount of life insurance each covers. It also considers assets and savings already available. Thus, it provides more personal calculations.
The needs-based approach is extremely flexible and very personal, so it’s a good choice if you want to make sure your life insurance accurately reflects the situation of your family’s finances.
Step 5: Consider the Coverage Term
Two basic categories of life insurance are term life and permanent life. Depending on your needs, each has different impacts on the coverage you will ultimately choose.
A. Term Life Insurance
Term life insurance has a term, usually ten, twenty, or thirty years. It is generally less expensive than permanent life insurance and best for people wanting to provide short-term protection for your family’s earnings replacement or mortgage over a certain period.
When to Opt for Term Life:
- You just need coverage for a short period of time, like until your children are out of college or your mortgage is paid off.
- You want an affordable option with high coverage.
Term life is usually recommended for people who have young children, particularly the fathers. For your child may not be vulnerable when you are no longer around to care for him or her, but these years create the foundation for a well-adjusted adult.
B. Permanent Life Insurance
Permanent life insurance provides lifetime coverage and has a cash value element that accretes over time as well. The two primary types of permanent life insurance are whole life and universal life insurance. Generally, they are more costly than term life, but permanently provide lifetime coverage for you.
When to Choose Permanent Life:
- You want coverage that will last your entire lifetime.
- You want a policy that earns cash value with time.
- You have an estate plan or you want to transfer your wealth.
For such cases, permanent life insurance is the ultimate solution if you want the benefit of ensuring your beneficiaries receive a death benefit irrespective of the date of your demise.
Step 6: Consider Inflation and Future Changes
In computing for your life insurance requirement, it must include inflation and other chances of changes in your life. As a rule of thumb, the cost of living increases and so does your family’s needs over time. For instance, the balance you still owe on your mortgage decreases as time passes since you will have been paying it, and your children will grow up eventually and become self-sufficient.
