If you’re like most people, you already know that having life insurance is a smart move to protect your loved ones from financial disaster. However, while it’s easy to understand the benefits of these policies, figuring out how much life insurance you need is more challenging.
All too often, it’s easy to look at a substantial payout like $50,000 or $100,000 and assume that it will be enough. However, coming up with a more precise number is always going to be the best option. After all, you don’t want to pay for more insurance than you need, and you definitely don’t want less than is necessary.
So, with that in mind, let’s take a look at the different variables you’ll want to take into account so that you can find the best amount for you and your family. Also, it’s imperative to recognize that your needs may change over time, so don’t assume that the amount will remain sufficient forever.
Breaking Down the Life Insurance Formula
If you were to ask an agent how much life insurance you need, he or she would probably give you an estimate of 10 to 20 times your current salary. However, if you want a more specific answer, a common formula is this:
Resources – Financial Obligations = Death Benefit
Your resources include any liquid assets (i.e., stocks), as well as any money coming in from you and your spouse. If you have other people living with you that contribute income, count that as well. Financial obligations include any bills (i.e., rent or utilities), and any debt you may have.
While this formula can give you a general sense of what to expect, we should break it down even further so that you can be sure you come up with the correct amount. Also, remember that your circumstances will change over time, so be sure to reset your numbers after significant life events, such as having a child.
For the most part, it’s pretty easy to calculate how much money you have coming in, as well as any assets you could liquidate immediately should the worst happen. For example, if your monthly salary is $3500 and your spouses is $3000, your families total income would be $6,500.
Liquid assets include stocks, mutual funds, money-market funds, and savings accounts. Basically, anywhere you have money that you can access quickly. Even something valuable like gold can be considered a liquid asset since there is always a market for it. Jewelry can be a little harder to factor unless you get an appraiser.
Realistically, though, any tangible items you have (like gold) should be evaluated so that you have an explicit and updated total. Also, be sure to take stock of these resources as they shift. Jewelry should be appraised regularly, and you want to pay attention to the price of gold over time.
While resources are relatively easy to calculate, financial obligations can be a little more challenging since there are often more bills than income streams. Let’s look at a few examples of financial obligations.
Unfortunately, most Americans have a lot of debt. So, if you are like the average household, chances are you have some debt on the books. Some examples of debt can include:
- Auto Loans
- Credit Cards
- Student Loans
- Personal Loans
What matters most is whether your loved ones are on the hook for any outstanding balances that remain once you die. What happens is that any assets you own are used to pay off debts, and any money left is distributed according to your will. However, if you don’t have sufficient funds to pay off this debt, other people may be responsible for it.
If your spouse is a co-signer on the loan, then he or she is liable for the remaining balance. Fortunately, co-signers don’t have to pay it off immediately – they simply take over the mortgage payments until the loan is finished.
Even if you didn’t have a co-signer, anyone who inherits the property is liable for the mortgage. So, if you are the sole owner and you leave it to one of your children, he or she is on the hook for the payments.
Because cards aren’t tied to any physical asset (like a home or car), most lenders are out of luck once you die. Credit card companies may solicit payments from family members, but unless someone was a co-signer for the card, no one is obligated to pay off a remaining balance.
What’s important to note here is that authorized users aren’t the same as co-signers. If you only authorized your spouse to use the card, he or she is not on the hook for that debt.
As with a house, the vehicle can be repossessed if no one makes payments on the loan. However, anyone who inherits your car can simply take over the payments and keep the vehicle.
Thankfully, your student loans cannot be shifted to family members or spouses upon your death. Again, if someone co-signed on the loan, he or she is responsible, but otherwise, lenders are out of luck when trying to collect.
It’s imperative that you know what kind of debt you have, and which bills will become a loved one’s responsibility once you’re gone. These are the only debts you should include when figuring out how much life insurance you need. While you may have $4000 in credit card debt, it won’t transfer to your spouse (as long as you are the sole proprietor).
Another thing to keep in mind is that in some cases, lenders may have the option to repossess property like your home or vehicle. Usually, lenders will want to maintain stability, so as long as your loved ones can assume the payments, that shouldn’t be a problem. Ideally, have your spouse or family talk to creditors as soon as possible to figure out what options they have.
While providing for your spouse is one thing, having kids to look after is quite another. The more dependents you have, the greater your life insurance needs. Let’s break down a few factors to keep in mind when calculating the value of your dependents.
Small children need extra care and attention. Whether you pay for childcare already or you’ll have to pay for it once you’re gone, the amount of life insurance can increase substantially because of it.
Also, remember that older family members can be dependents. If grandma or grandpa is living with you, you have to calculate those costs as well. As they get older, continuing care will become more expensive, so keep that in mind.
Even if your children attend public school, chances are that they will go to college as well. Unfortunately, college tuition isn’t cheap, so you will have to plan accordingly. Not only that, but you may not know which school your child wants to attend, or whether he or she can get financing for it. Overall, you want to assume that your life insurance benefit will have to pay for everything in full.
Another thing to consider is if your children are going to private school, or are planning to in the future. Also, take into account all aspects of school, from uniforms, textbooks, to living expenses.
When calculating how much life insurance you need, you can’t forget that there are significant costs associated with death. Burial, cremation, funeral expenses – none of these things are cheap, and they can add up quickly.
Again, remember that end-of-life expenses can inflate over time, so be sure to adjust your life insurance as necessary. Also, now is the time to have a conversation with your spouse (and kids, if they are old enough) to share how you would like your funeral to be held.
It’s imperative that your loved ones are fully aware of your wishes. First, to ensure that you are honored the way you like, and second, to make sure that they don’t spend more than you accounted for in your planning. For example, if you want a simple cremation and low-key ceremony, discuss those plans with your family.
Other Considerations When Calculating Life Insurance
We’ve covered the essential elements of the life insurance formula, but that’s not all there is to this process. Before you settle on an amount, be sure that you factor in any other potential game-changers.
Age and Health
Buying life insurance is not the same for everyone. Also, depending on your current health status, it may change for you if you wait to buy it. Most life insurance companies will want to get as much information about your medical history before drafting a policy. You may be subjected to a physical exam.
Overall, you want to buy life insurance when you’re relatively young and healthy. If you have any serious or chronic health conditions, that can impact your ability to get the coverage you want. In some cases, you may have an amount in mind for your death benefit, but because of your health, it might be out of reach.
Also, consider how likely it is that you could die unexpectedly. If you’re in good shape, then chances are you won’t keel over at random. However, if your family has a history of heart problems around a certain age, that can be a warning sign you can’t ignore.
Determining how much life insurance you need shouldn’t mean that you come up with a precise number. If, after using the formula, you decide that $125,000 is enough, it may be best to add a cushion as well.
While you don’t want to go overboard, adding a few extra thousand can help provide some additional breathing room. Your loved ones will be going through a lot if the worst happens, and worrying about covering all of your bills shouldn’t be one of them.
This cushion can be used for a variety of things, such as food, clothing, and other essentials. Depending on your situation, this buffer can offer much more stability. For example, if your spouse doesn’t work right now, it may take a while for him or her to get gainful employment. Having some extra money can ensure that your family isn’t hurting during that transitional period.
Just because you decide that $200,000 is enough life insurance for your loved ones doesn’t mean that you can afford it. When talking with your agent, be sure that you know the maximum price that will fit into your budget. Ideally, you will be able to get the right coverage without paying an arm and a leg, but it’s crucial that you understand that may not be the case.
The type of coverage you get can also affect your premiums. Term life insurance, for example, is usually cheaper, but it only covers you for a specific period (or term). Whole life insurance will continue for as long as you pay for it, but monthly costs can be much more expensive.
Bottom Line: Do Your Homework
You don’t want to leave anything to chance, so doing your due diligence is always the smart choice. Also, remember that you can compare plans and talk to your agent about the right move for your situation.