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You might be asking yourself this question: "How much life insurance do I need?"
Some financial advisors will tell you to multiply your annual income by seven. Others will tell you to buy only enough life insurance
to replace the income you are expected to make between now and
retirement. Some might recommend you buy only enough life insurance to
cover your present debts.
While you probably can do all of those calculations
in a minute, they won't give you the right answer. Simply put,
calculating your life insurance needs takes homework. It requires you
to do an inventory of all of your finances, and to think long and hard
about how your beneficiaries would maintain their lifestyles without
you. You also must consider inflation and, if you have children, future
college education costs.
What's the wrong way to calculate how much life insurance you need? Here are some common but misguided methods.
No. 1: Don't multiply your annual salary by seven
or eight: While it's a simple formula, it fails to take into account
your individual needs and obligations. Life insurance experts say
there's a good chance you'll buy too little coverage or more coverage
than you need by using a formula such as this.
No. 2: Don't calculate your "human life value":
This method uses the income you will earn from your present age until
your retirement age, assuming estimated salary increases throughout
that period, and then calculates the "present value" of that total.
The
present value is an estimate of the amount of income your family would
lose if you were to die today. The problem is it does not take into
account what your beneficiary's specific needs are. You may also end up
with a figure that indicates you should buy a huge amount of life
insurance, possibly more than you may need.
"Focusing on any one aspects of an individual’s
financial life can create problems," says Michael Snowdon, a personal
finance planning and insurance management professor at the College for
Financial Planning in Denver.
"Simply replacing future earnings is a little too
simplistic an approach to an otherwise complex financial concern. Far
better is to work through a needs analysis to determine what needs
actually exist and then work to meet those needs.”
No. 3: Don't just cover your debts. This method
involves buying only enough life insurance to cover debts such as your
mortgage, student loan bills or car loans. It does not consider any
future debts or needs, such as child care or college education costs.
A must-know: The equation for the future value of money
Calculating your life
insurance needs will require
two equations you may have picked up in Finance 101: the future and presentvalue of money.
The
future value of money equation tells you how much your money will be
worth in a given number of years at a specified rate of interest. This
equation is essential if you are calculating how much money you'll need
in the future because of inflation, or what the amount would be if you
choose to invest the money at a given interest rate. The present value of money equation tells
you what money payable in the future is worth today at a given rate of
interest. This is important if you have an amount of money you need in
the future, and you need to know how much money you must invest today
to achieve it.
If this sounds
complex to you, don't fret. As long as you have a calculator
(preferably a financial calculator, which is used by accountants and
finance professionals), these equations are no sweat.
Here's
how the future value of money equation works: Say that average college
education costs are $20,000 annually for a private four-year
institution, and you want to figure out how much it will cost in four
years if college costs keep going up 5 percent per year. You would
multiply 20,000 by 1.05 (1 represents the present cost, and .05 is 5
percent inflation) four times (or 1.05 to the fourth power).
So your equation would be
this:
20,000 x (1.05)^4
or
20,000 x (1.05)(1.05) (1.05)(1.05)
The answer is $24,310.13. |
Many experts say the best way to calculate the
amount of life insurance you need is through aneeds analysis, which can
be broken down into a simple formula:
Short-term needs + long-term needs - resources = how much life insurance you need.
Snowdon says this method is "probably the most accurate approach in what is an inaccurate and imprecise science."
Experts advise you do an analysis at least once
every three years, or whenever you have had a major life change. For
example, if you have a new baby, you have to recalculate college
education needs and child-care costs. If you own a home, a mortgage is
likely your biggest financial burden. Because your mortgage balance
decreases with each payment, it's important to include those revised
figures in your calculations.
Add up all of your short-term needs. These can be placed into three
categories: final expenses, outstanding debts and emergency expenses.
Among final expenses are medical, hospital, and funeral expenses,
attorney and executor fees, probate court costs, and any outstanding
taxes that would need to be paid if you died. Among typical outstanding
debts are credit card balances, auto loans, college loans, and all
other outstanding bills. Emergency expenses should include a cash
reserve for medical emergencies and repairs to your home or car.
Calculating
final and emergency expenses can be complicated, because you don't have
a crystal ball that tells you how much your medical or hospital
expenses will be, or if you even will have any.
Next, add up your long-term obligations, which include your mortgage and college tuition.
Calculating
an education fund is tricky because you have no idea where your
children will be going to college. Perhaps the best method is to use
the present average college cost in the United States and the number of
years away your children are from entering college. The average college
costs for the 2007-2008 school year were $6,185 annually for a public,
four-year institution, and $23,712 annually for a private, four-year
institution, according to The College Board. These tuition costs
represent an increase of 6.6% and 6.3%, respectively, from the previous
school year.
Next,
calculate family maintenance expenses. These include such necessities
as child care, food, clothing, utility bills, entertainment, travel and
transportation. Calculate this figure based on a year's worth of
expenses, then multiply that times the number of years you want to
provide this income.
Now that you've tallied all of your income needs,
figure out what resources you have to meet them. To do this, add all
available savings, stocks, bonds, mutual funds, the death benefit
payable under existing life insurance (such as group life through your
employer) and Social Security. You and your spouse can find out how
much you'll get through the Social Security Administration (SSA) by
visiting the SSA's Web site, where you can get an estimate of how much you should have in Social Security benefits.
The final figure that shows how much life insurance you need can be quite unnerving. |
It's
important to count only liquid assets (those that could be quickly
converted to cash) among your resources. You shouldn't count items such
as your home or automobile, because selling them for cash after you die
would mean changing your family's lifestyle.
Subtract your resources from the amount of capital
needed to meet your family's total financial needs. The figure you get
represents the amount of life insurance you should buy.
Insure.com's Life Insurance Needs Estimator Tool can help with your calculations.
Snowdon
says the final figure that shows how much life insurance you need can
be quite unnerving. If you end up with a figure that requires a premium
that is too high, he recommends you go through the analysis again and
select areas in which you think your family can get by with less money.
"Many
people will think they can't afford coverage based on sticker shock,"
Snowdon says. "You have to look at the figure again to determine what
is absolutely necessary and make your adjustements."
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