It’s tricky to put an exact dollar amount on how much life insurance you need, but there are proven methods and tools to guide you. One of the easiest ways to begin is by using a life insurance calculator; however, understanding how the calculation is made is important.
The Core Principle: Financial Obligations Minus Assets
In essence, find the gap. You should generally add up your long-term financial obligations, such as mortgage payments or college fees, and then subtract your assets. The difference is the amount that life insurance needs to cover. This helps ensure that your loved ones are provided for financially.
How to Manually Calculate Your Life Insurance Needs
Follow this general philosophy: financial obligations minus liquid assets equals your target coverage amount.
Step 1: Calculate Your Financial Obligations
Add up the following elements:
- Your annual salary multiplied by the number of years you want to replace that income.
- Your mortgage balance.
- Any other debts (credit cards, loans, etc.).
- Future needs like college fees, and funeral costs.
- The cost to replace services provided by a stay-at-home parent such as childcare, if needed.
Step 2: Subtract Your Assets
From the total calculated in Step 1, subtract your liquid assets (savings, investments, etc.) and any existing college funds or life insurance policies.
The remaining number is the amount of life insurance coverage you need.
Simplified Methods for Estimating Coverage
If you want a quick estimate of your life insurance needs, these methods can provide a starting point. However, keep in mind that these often fail to account for the specifics of your financial situation.
- Multiply Your Income by 10: This often-cited guideline doesn’t consider savings or existing life insurance. It also doesn’t account for stay-at-home situations.
- 10 Times Income Plus $100,000 Per Child: This includes coverage for education costs, which is a good start if you have kids. However, it still lacks a comprehensive view of your finances.
The DIME Formula: A More Detailed Approach
The DIME formula encourages a more comprehensive look at your finances:
- Debt and Final Expenses: Calculate your debts (excluding your mortgage) and estimate funeral costs.
- Income: Determine how many years your family will need financial support. Multiply your annual income by this number.
- Mortgage: Calculate the amount needed to pay off your mortgage.
- Education: Estimate the cost of your children’s education.
By adding these obligations, you get a more comprehensive view of your needs. Still, it doesn’t factor in current life insurance coverage.
Replace Your Income Plus a Cushion
This method aims to provide enough coverage so beneficiaries can replace your income without spending the payout itself. The benefit is the ability to invest the lump sum, which provides a financial safeguard.
To calculate the amount, divide your annual income by a conservative rate of return (like 4% or 5%). For example, if your income is $50,000 and you estimate a 5% rate of return, you would need a $1 million policy ($50,000 / 0.05 = $1,000,000).
For a stay-at-home parent, first calculate the annual cost to pay someone to handle those duties, then use this figure as the ‘income’ in the formula.
Tips for Calculating Your Life Insurance Coverage
- Integrate with your financial plan: Take into account future expenses, such as college costs, and the future growth of your income or assets.
- Do not skimp: Income and expenses will increase with time. A financial cushion guarantees that your family can keep a consistent standard of living.
- Talk with your family: How much money does your spouse realistically think the family would need without your income? Is it your full income or just a portion?
- Consider smaller, multiple policies: Multiple policies let you adjust coverage as your needs change. For instance, you could purchase a 30-year term life insurance policy to cover your spouse until retirement age and a 20-year term policy to cover your children until they graduate from college.
Term vs. Whole Life Insurance
- Term life insurance lasts for a specific period (10, 20, or 30 years, for example), so the length of time you want the policy to last is a critical consideration. For example, if you need insurance to cover your income until your children go to college, you may need a 20-year policy.
- Whole life insurance can last for your entire life. Consider final expenses (such as burial costs) if this type of policy suits your needs.
