How much life insurance do you need?
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 conduct an inventory of your finances and think 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 not to do
Not good at math? Insure.com's Life Insurance Calculator can help you determine the right amount of coverage.
What's the wrong way to calculate how much life insurance you need? Here are some common but misguided methods.
- 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.
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.
- 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 classic formula
Many experts say the best way to calculate the amount of life insurance you need is through a needs 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.
Five steps to a life insurance needs analysis
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 present value 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
20,000 x (1.05)(1.05) (1.05)(1.05)
The answer is $24,310.13
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.
Add up your long-term obligations. This includes 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. According to The College Board, tuition can vary from $36,000 for a public, four-year institution to $120,000 or more for a private, four-year institution.
- 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.
Don't be daunted
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 adjustments."