How Much Life Insurance Should I Buy?: While life insurance is rarely required, it often becomes a consideration when you begin a family or have loved ones that depend on you financially. In these cases, how much life insurance you need is directly tied to your reason for purchasing a life insurance policy. If you have a mortgage and are the primary earner for your family, you would need a much larger life insurance policy than if you just wanted to cover your end-of-life costs. A simple rule of thumb is that you should buy enough life insurance to cover all major upcoming financial obligations, assuming your family also had access to your liquid assets.
How Much Life Insurance Should I Buy?
How to Calculate the Amount of Life Insurance You Need
A commonly shared rule of thumb for determining your life insurance needs is to purchase a policy with a death benefit equal to 5 to 10 times your annual income. While this is a quick formula, it’s unlikely to reflect what your actual needs are. The amount of financial protection your family would need changes over time as children finish school and debts are paid.
A better rule of thumb is to add together your current and future financial obligations, then subtract all assets that would be liquidated if you pass away.
How to Calculate Debts & Financial Obligations
Financial obligations can typically be divided into the categories of: current debts, income replacement and future expenses.
Current debts typically would include a mortgage, auto loan, credit card balance and other personal loans. Depending on how your finances are organized, you may not need to include all of these loans when calculating your life insurance needs. For example, an outstanding mortgage should usually be accounted for in your life insurance death benefit, as you don’t want your family to have to move following your death. On the other hand, if you don’t live with a partner, your children have their own homes and your house’s current value is greater than your outstanding mortgage balance, you may not need to include it.
It can be challenging to determine how much life insurance you would need as income replacement, as an accurate figure would require you to evaluate your family’s ongoing expenses, future expenses and savings plan. You can do a simple approximation by adding the following figures together:
- Children: Estimate the amount of money you spend on children (the average is around $13,000 per child per year, though this figure varies by age). Multiply this figure by the number of years until your children move out.
- Spouse: Subtract the cost of your children and mortgage from your annual household budget. Multiple this figure by the number of years you would expect your spouse to live. For reference, a woman that is currently 35 would be expected to live to 86, according to the Social Security Administration, while a 35-year old man would be expected to live to 82.
Since this is an approximation, the figure you come up with is likely higher than your family’s actual needs. However, you still need to account for your family’s upcoming expenses. These may include the cost of sending your children to college, your spouse purchasing a new car, paying for an elderly parent’s long term care or even helping fund a child’s wedding.
Typically, education costs are one of the largest expenses that needs to be accounted for when purchasing life insurance. According to The College Board, the annual all-in cost (including tuition, fees, room and board) of sending a child to college this year is:
- $20,090 for a public in-state college
- $35,370 for a public out-of-state college
- $45,370 for a private nonprofit college
By adding together your current debts, income replacement needs and future financial obligations, you have a figure that represents the maximum amount of life insurance you might need.
How to Calculate Your Assets
The next step is to add together your assets and other sources of income. This figure will be subtracted from your total financial obligations in order to determine your actual life insurance needs.
When adding together your current assets, you should include brokerage accounts, savings accounts and any existing life insurance policies. However, you should exclude retirement accounts, such as a 401(k) or IRA.
Also, if your family has multiple earners, take their after-tax income and multiply it by the number of years they intend to work. Include this in the sum of your assets.
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Things to consider before purchasing life insurance
The next step involves the critical part of deciding which life insurance product provides the best solution to your requirement. The first 5 things you need to consider are:
- Assess your insurance needs: What is your contribution to the family income and how many are dependent on you financially. Is there anything that your family can depend on to meet expenses and repay debts after your premature death? Answers to these questions should help you decide how much coverage you need. Consult an insurance agent who can give you information on life insurance products as well as someone who can help you in evaluating your insurance needs. The assessment exercise should ensure the amount of life insurance cover you buy will provide the much-needed financial protection to your family after your death.
- Compare insurance policies: The two basic types of life insurance are term insurance and savings-cum-protection insurance. Term insurance provides indemnity against events that would otherwise be financially distressing. Term insurance is cheap – a large insurance cover can be had for a smaller premium. There is no payment made by the insurance company if the insured survives the policy period. In contrast, savings-cum-protection insurance gives you a maturity benefit which is equal to the sum insured plus bonus additions. Term insurance is only for financial protection of your dependents against an unforeseen event where you do not receive any personal benefit. Your choice should depend on your needs, both immediate and future.
- Choose a cover that you can afford: After assessing your life insurance needs, determine how much it will cost you in terms of annual premiums. Before purchasing a life insurance policy, check if you can afford to pay premiums for the entire policy term. If your insurance need is larger, it wouldn’t make sense to go for a savings-cum-protection plan. A term insurance policy will suit you as it is cheaper and you will be able to afford the premium. The first goal of insurance should be protection. You could go in for a savings-cum-protection plan subsequently if you think it’s possible for you to pay high premiums regularly.
- Evaluate the future of your insurance policy: Take the help of your insurance agent to understand the finer points of your policies. Exclusions – events that are not covered by your insurance policy – are critical. Know them before you buy the insurance policy rather than leaving you and your dependents in shock when the moment of truth strikes.
- Check the claim settlement history of the insurance company: You buy an insurance policy so that in the event of a future need, your insurance company pays the promised benefit or benefits. Just as the insurance company verifies your insurability, check the claims payment ratio of the insurance company. It does not take much to do a research online on the claims history of an insurance company. The IRDAI also provides claims related information on its website. The insurance company may have rejected some claims but you need to check the reasons behind the decisions. Insurance companies cannot and will not pay if a claim is a fraudulent one or is not payable for some other reason. Knowing how much insurance protection to buy and from whom is not enough. It is essential that you do it when you are young so that you could be adequately insured.
What Kind of Life Insurance Do You Need?
Once you’ve calculated how much life insurance you should buy at the moment, you should calculate how long you’ll need this amount of coverage. This is important because the cost of a life insurance policy is correlated to the number of years it lasts, since you’re more likely to pass away during the period of coverage.
For each financial obligation, you should determine whether it’s time-specific or time-independent. A time-specific cost would only impact your family during a particular period of time. As an example, if your child is 12, you would expect that their college costs were handled within the next 10 years. A funeral is a common time-independent obligation, as it’s a cost that could happen at any point.
For most families, the majority of projected expenses are time-specific. If this is the case, we would recommend term life insurance as it’s the cheapest type of policy and offers for a particular amount of time. Term policies can range from 5 years to 35 years in length and can provide over $1 million in death benefits.
If you have costs that aren’t limited to a specific period of time, there are two main options:
- Buy term life insurance and save – Term life insurance is significantly less expensive than permanent coverage. If you can save enough money to simply cover the expense, just buy additional term coverage for the amount of time it will take to do so.
- Buy permanent life insurance – While whole life insurance is the most common form of permanent coverage, it’s quite expensive because it has a cash value investment component. If you just want a lifelong policy to cover all your financial obligations, guaranteed universal life insurance has the best rates and coverage can last until you’re 121.
- SEE ALSO: How to choose between term vs whole life insurance
Whether you buy term or permanent coverage, just make sure that premiums are level for the entire length of the policy. When this isn’t specified, the insurer can raise your rates and you may not be able to afford the coverage later, even though it’s still needed.