How Much Life Insurance Do I Need?
B.A. Risk Management
Life Insurance Agent
When it comes to buying life insurance coverage, the first and perhaps the most important question you need to ask yourself is – how much life insurance do I need?
You need to buy enough life insurance to cover all debts, replace lost income, pay off your mortgage, and pay for your children's education.
Why This Is Important
If you are the primary breadwinner of your family, buying life insurance is the only way to make sure that your family does not have to rely on anyone else for their financial needs in your absence.
If you miscalculate the amount of life insurance coverage you need, the payout from your policy might not be sufficient to cover your family’s financial needs, in which case they might have to sell off their assets or borrow money.
To avoid such a scenario, you should make sure that the insurance coverage you buy is sufficient to pay off all your debts and take care of your family’s needs.
How to Determine How Much Life Insurance to Buy
In this article, we discuss the key factors you need to consider while determining the amount of life coverage you need.
The DIME Formula
One of the easiest ways to calculate your life insurance needs is to apply the DIME (debts, income, mortgage, and education) formula. This is the formula that you should use in addition to using a term life insurance calculator. Write it down on a piece of paper, don't trust someone else's calculator unless it shows you the math.
Calculate the total amount of personal debts you have – from credit cards to personal loans, business loans, and car loans.
Collect all the required documents (credit report, bank statements, credit card statements, and loan statements), make a detailed list of all the debts you have, and add everything up. The resulting number should be factored into your life insurance coverage calculations.
The primary objective of buying a life insurance policy is income replacement in the event of your untimely death.
This is particularly important if you have a stay-at-home spouse and young children who are entirely dependent on your income.
Based on your current income, the size of your family, and your family’s needs, you can figure out how many years your family might require financial support in your absence and multiply your yearly income by the number. A good rule of thumb is to replace 10 years of your annual salary.
For example, if you make $50,000 a year and if you believe that your family might need financial assistance for at least 10 years after your death, you need at least $500,000 ($50,000 x 10) in life insurance coverage.
A mortgage or home loan is the biggest financial obligation that you are likely to commit yourself to in your life. It is also the debt you are likely to carry for the longest period – anywhere from 15 to 40 years.
So, it is absolutely essential for you to make sure that the burden of mortgage is not passed on to your family in the event of your untimely death.
This is particularly important if you have a stay-at-home spouse and the entire family is dependent on your income. In the absence of life insurance coverage, the death of the primary wage earner usually leads to one of the following two scenarios:
- Your family is unable to keep up with the mortgage payments. So, the lender decides to foreclose your property.
- Your family decides to sell the house to pay off the mortgage.
In both these cases, your family will have to let go of the property that you toiled hard to buy. This is precisely why you need a life insurance policy whose payout should be sufficient to repay the mortgage in full.
One thing you need to be aware of is that lenders usually try to sell life insurance coverage along with home mortgage.
These policies are meant to cover the mortgage amount so that the lender does not suffer any losses in case you pass away without repaying the mortgage in full.
Most of these policies are also structured in such a way that the death benefit paid out by the insurance company goes directly to the lender. Your family does not receive the money nor does it have any say over how the money gets spent.
It’s prudent to avoid these policies altogether and instead buy a traditional life insurance policy whose payout covers all your financial needs, not just your mortgage. Read more on mortgage life insurance.
If you have young children, you should have a plan to fund their college expenses until they graduate. Data shows that American parents, on average, pay $35,830 (per person) for private college education and $10,230 for public college.
The numbers represent tuition expenses alone and do not include food, boarding, and other expenses. So, you certainly need to factor in your children’s educational expenses into your life insurance coverage calculations.
There are a number of factors you need to consider while calculating your children’s educational expenses.
These factors may include the number of children you have, the state you live in (school/college fees greatly differ from one state to another), the college your children plan to go to (public or private), and the major they are likely to choose (STEM degrees are more expensive than humanities/liberal arts because those jobs in those fields pay more than jobs than a liberal arts degree leads too).
Other Factors to Consider While Calculating the Amount of Coverage You Need
This is something you are unlikely to dwell on, especially if you are young and in good health. It is, however, an important factor you need to consider while calculating the amount of life coverage you need.
Data shows that funeral costs are between $7,000 and $9,000. The cost can significantly go up depending on the type of casket, gravesite, coffin container, and headstone your spouse/family chooses for the ceremony.
This is a burden that you do not want to pass on to your family, especially when they are grieving for your loss and are likely to be in an emotionally vulnerable state of mind. So, you need to make sure your life insurance coverage includes the cost of your funeral expenses as well.
The DIME formula mentioned above only takes your children’s educational expenses into account. If you, however, have young children, the cost of childcare should also be considered while calculating the coverage amount you need.
The average cost of raising a child – assuming you are from a middle income household – could be as high as $233,000. Needless to say, it could be too big of a financial burden for your family to bear in your absence, especially if you have a spouse who does not work.
So, you should make sure that the life insurance coverage you buy is sufficient to cover the costs of raising your children – without requiring your family to lower their standard of living in any way.
If you are young (mid 20’s to early 30’s), have considerable financial obligations, and have young children, the life insurance coverage you buy should be at least 10 to 15 times your yearly income. The idea is to provide your family with financial assistance until your children grow up, go off to college, and start living independently.
If you, on the other hand, are in your 40’s and have teenage kids who are about to go off to college in a few years, you might not need a substantial amount of coverage.
This is something you need to keep in mind while calculating the amount of coverage you need.
Term Life Insurance vs. Permanent Life InsuranceAt NoExam.com, we have always maintained that term life insurance is the best choice for most people who are looking to buy life insurance coverage at affordable rates. Other types of life insurance, like whole life insurance, are not a good choice. Read more on the difference between term and whole life.
If you are a 25-year old man who does not smoke and is in very good health, a 20-year, $500,000 term life insurance policy is likely to cost you just over $20 a month. It is impossible to find a permanent life policy which offers the same amount of coverage at such low rates. The drawback of a term life policy is that it only offers coverage for a set period of time. This is usually not a deal breaker, as your life insurance needs will be reduced over time.
There are, however, certain situations in which buying a permanent life policy (whole life or universal life) might make more sense than buying a term plan.
- If you have a large estate which is likely to attract federal as well as state taxes, you can buy a permanent life policy so that your beneficiaries can use the payout to pay the taxes.
- If there are members in your family who are financially dependent on you (aged parents, disabled siblings, or a child with special needs), a permanent life policy is the best way to make sure their financial needs are met in your absence.
- If you want to leave a large sum of money for charity or leave a legacy for your family, a permanent life plan might be a wonderful choice.
Life Insurance Coverage – A Need, Not a Want
Life insurance is the most affordable way to make sure that your loved ones do not have to rely on others for their financial needs in your absence. Especially, if you belong to a lower-income or middle-income family, life insurance is a basic need, not a want.
So, it’s a good idea to buy life insurance coverage – for yourself as well as your family – when you are young and healthy, since you can buy as much coverage as you need at very cheap rates.
If you have any questions with respect to life insurance or if you are not able to find the right policy for yourself and your family, you can get in touch with the experts at NoExam.com.
We can answer all your questions, clarify the common misconceptions about life insurance, and help you choose a policy which is best suited for your budget as well as long-term financial needs.