How much life insurance do you really need?
Figuring out how much insurance you can afford is a good place to start.
When my wife and I first had children, one of the big questions I asked was a familiar one: How much life insurance do I need?
While nobody likes to think of his or her own demise, it's prudent to consider what financial ramifications your death could have on those you leave behind. It gives me tremendous peace of mind to know that if I die, my wife will have enough to pay off all our debts and take care of our family. But while it's hard to dispute the sensibility of life insurance in general, many people disagree on how much life insurance you should have.
If you're wondering how much life insurance you should buy, here are some things to consider:
Rules of thumb. When it comes to buying life insurance, there are some rules of thumb to help you determine how much you need. While no rule of thumb should be followed blindly, they can be a good starting point for further analysis. Here are several widely used rules of thumb when it comes to buying life insurance:
- Salary times 17. Take your annual salary and multiply by 17. So, if you make $75,000 a year, with this approach you'd buy $1.27 million in life insurance. With that amount, your beneficiary should be able to replace your income with interest and dividends earned from investing the life insurance proceeds. In effect, the 17-times-salary rule of thumb is an income-replacement-for-life model.
- Sliding scale. Some refine the multiplier based on your age. The younger you are, the higher the multiplier. For example, a 20-something would multiply annual salary by 20, while somebody nearing retirement would multiple income by five.
- Five to 10 times salary. If you're not looking to replace your salary for life, many suggest five to 10 times salary. The idea of this rule of thumb is to help your loved ones pay off debt and have time to grieve without the added stress of financial worry.
What can you afford? Regardless of how much coverage you need, think you need, or someone says you need, a critical financial consideration is how much life insurance you can afford. Exceeding a balanced budget isn't in keeping with sound financial planning, no matter the line item.
Admittedly, adjusting your spending in other areas to increase the premium you can afford may be prudent. Bottom line: Don't ask your family to live like paupers now so that, in the eventuality of your death, they can live like kings.
Make this your first order of business. This will help you to explore your maximum coverage without being stressed or tempted to buy more than you can afford. Find your maximum monthly payment, and stick to it as you seek quotes.
What is your minimum coverage? None of us would mind making our families comfortable for the rest of their days. But before we tally up a $10,000 payoff for every second cousin, let's consider the bare minimum you need. Typically, the most important factor people consider is liabilities. Is there a car payment? A home mortgage? A serious desire to provide for your child's college education? Evaluate what debts and costs your family will have to face without you. Burial costs are another expense to consider.
- Calculator: Do you have enough insurance?
What do you want to accomplish? The bulk of your baseline coverage amounts should be dictated by the minimum coverage requirements you just tallied, but there are those who do want a considerable amount more than what will meet their family's financial obligations. Many people evaluate what it would take to enable their grieving spouse to mourn for a year or two before returning to work. Others want to replace their income for life, so that a spouse never has to return to work. Again, this depends almost completely on your individual lifestyle. So give thought to what you'll want the money to cover over and above paying off your debt.
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Rules of thumb revisited. As described above, most rules of thumb for life insurance involve multiples of your salary. If you're looking for minimum coverage, I'd say stick with the tally of your basic liabilities and goals. This will be more realistic and likely more affordable than blindly following a rule of thumb. However, if you want your family to continue receiving the equivalent of your monthly paycheck for X number of years, then a multiple of your salary is a good approach to choosing the amount of life insurance to buy.
Don't forget about terms. I've made the assumption that your search for life insurance will likely bring you to the conclusion that term life insurance will meet your needs. To get a sense for the differences in life insurance (term, whole, permanent), check out our article discussing permanent life insurance.
At the same time you're deciding on how many dollars of coverage you'll need, you'll also be faced with the question of how many years you'll need the coverage. Ultimately, most financial gurus advocate self-insuring during the latter half of your life. Self-insuring simply means that you have enough money and assets to achieve the same financial goals you have identified above.
- In the event of calamity, some life insurance is better than none. Don't put off the decision.
- You can always layer coverage using multiple policies, meaning if you didn't buy enough coverage the first time, you can get additional coverage through another policy.
- People joke that you want to have enough coverage to make your spouse comfortable, but not enough to make him or her too comfortable with the idea of living without you. There might be something to that.
- Perks and rewards are obviously secondary to premium amounts and coverage, but different insurers offer different benefits and features. Check to see if you receive any premium back at the end of your term, additional accidental death payouts, and terminal illness payouts.
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