How Much Life Insurance Should You Carry?
Death, like taxes, is unavoidable, though most people prefer not to think about it. However, if you have loved ones who rely on your income, you must ensure that you have adequate financial resources in place, including life insurance. Life insurance can help pay for funeral and burial expenses, settle outstanding debts, and make day-to-day living expenses less burdensome for those you leave behind.
If you don't have life insurance or are unsure whether your policy is adequate, here's how to assess your coverage needs.
What Is Life Insurance?
Life insurance is a contract in which an insurance company agrees to pay a predetermined amount after the death of an insured party, as long as the premiums are paid on time. This sum is known as a death benefit. Policies provide insured people with the assurance that their loved ones will have peace of mind and financial security in the event of their death.
There are two types of life insurance: whole life and term life. Whole life policies are a type of permanent life insurance, which means you're covered for the rest of your life as long as you pay your premiums. Some whole-life policies include an investment component that allows you to accumulate cash value by investing the premiums you pay.
Term life insurance, on the other hand, covers you for a specific period of time. For example, depending on your age and how long you need coverage, you could purchase a 20- or 30-year policy. Some policies allow you to renew your coverage after it has expired, while others require a medical exam. Term life insurance typically has lower premiums than whole life insurance.
Who Needs Life Insurance?
Life insurance can be a valuable financial tool, but it is not appropriate for everyone. If you're single and have no dependents, and you have enough money to cover your debts as well as death-related expenses (funeral, estate, attorney fees, and other costs), you may not need life insurance. The same is true if you have dependents and sufficient assets to provide for them after your death.
However, if you are the primary provider for your dependents or have significant debt that outweighs your assets, insurance can help ensure that your loved ones are well taken care of if you die. A life insurance policy may also make sense if you own a business or have cosigned debts, such as private student loans, for which you may be held liable if you die.
Remember that life insurance does not cover every situation. A standard life insurance policy, for example, will not pay disability benefits if you become disabled, nor will it cover long-term nursing care costs. However, for an additional premium, you can purchase disability riders or long-term care insurance riders to cover these types of scenarios.
Age and Life Insurance
One of the most common myths that life insurance agents spread is that if you don't buy a policy when you're young, you've missed out. According to the industry, getting life insurance policies becomes more difficult as you get older. Insurance companies profit by speculating on how long people will live.
It is true that insurance is less expensive when you are young. However, this does not imply that qualifying for a policy is any easier. The simple fact is that insurance companies want higher premiums to cover the risks associated with older people, but it is extremely rare for an insurance company to refuse to cover someone who is willing to pay the premiums associated with their risk category. That being said, get insurance if and when you require it. Don't get insurance because you're afraid you won't qualify later in life.
Should You Use Life Insurance as an Investment?
If you have a policy that builds cash value, you can think of life insurance as an investment. Cash value policies are frequently promoted as an additional way to save or invest for retirement. These policies assist you in accumulating a pool of capital that earns interest. This interest accumulates because the insurance company, like banks, invests that money for its own benefit. In exchange, they pay you a percentage of your money's value.
However, it is critical to consider the potential rate of return. If you take the money from the forced savings program and put it in an index fund, for example, you might get a better return. A cash value insurance policy may be beneficial for people who lack the discipline to invest on a regular basis. A disciplined investor, on the other hand, may be able to generate higher returns by investing the money they would pay in market premiums.
What Is the Minimum Amount of Life Insurance You Need?
Choosing a life insurance policy involves determining how much money your dependents will require. The face value—the amount your policy will pay out if you die—is determined by a number of factors. As a result, the minimum amount of coverage you require may differ greatly from what someone else requires. Although your personal number may be higher or lower, financial experts frequently recommend purchasing 10 to 15 times your annual income in coverage. Here are some of the most important factors to consider when deciding on a minimum amount of life insurance.
Debt
Outstanding debts, such as student loans, car loans, mortgages, credit cards, and personal loans, can be paid off with life insurance. If you have any of these debts, your policy should provide sufficient coverage to pay them off completely. So, if you have a $200,000 mortgage and a $4,000 car loan, you'll need at least $204,000 in coverage to cover your debts. But don't forget about the appeal. You should also take out a little more to cover any additional interest or charges.
Income Replacement
One of the most important aspects of life insurance is income replacement. If you are the sole provider for your dependents and earn $40,000 per year, for example, you will require a policy payout large enough to replace your income plus a little extra to protect against inflation.
To be on the safe side, assume that your policy's lump sum payout is invested at 8%. To replace your income, you'll need a $500,000 policy. This is not a hard and fast rule, but adding your yearly income back into the policy ($500,000 + $40,000 = $540,000 in this case) is a decent inflation hedge. You can begin shopping for insurance policies once you have determined the required face value. There are numerous online insurance estimators that can assist you in determining how much insurance you will require.
Insuring Others
Other people in your life are obviously important to you, and you may wonder if you should insure them. As a general rule, only insure people whose death would result in a financial loss to you. While the death of a child is emotionally devastating, it does not result in a financial loss because children are expensive to raise. The death of an income-earning spouse, on the other hand, results in both emotional and financial losses.
In that case, use his or her income to complete the income replacement calculation. This also applies to financial relationships with business partners. Consider someone with whom you share responsibility for mortgage payments on a jointly owned property. You should think about purchasing a policy for that person, as their death will have a significant impact on your financial situation.
Methods of Calculating Life Insurance
According to most insurance companies, a reasonable amount for life insurance is six to ten times the annual salary. If you multiply your annual salary by ten, you'd choose $500,000 in coverage. Some experts advise adding an extra $100,000 in coverage per child above the 10x amount.
Another method for determining the amount of life insurance required is to multiply your annual salary by the number of years until retirement. For example, if a 40-year-old earns $20,000 per year, they will require $500,000 in life insurance (25 years $20,000).
The standard-of-living method calculates how much money survivors would need to maintain their standard of living if the insured party died. Take that figure and multiply it by 20. The thought process here is that survivors can withdraw 5% of the death benefit each year (the equivalent of the standard-of-living amount), while investing the death benefit principal and earning 5% or better. This method of calculation is also known as the human life value (HLV) approach.
DIME is another methodology (debt, income, mortgage, education). This is intended to provide a small amount of coverage to cover family expenses in the event of an untimely death. Using the DIME method, your coverage should be sufficient to cover all of your outstanding debts (including your mortgage), pay for your children's education, and replace your income for as many years as your children are under the age of 18.
Alternatives to Life Insurance
There are alternatives if you only want life insurance to cover debts and have no dependents. Lending institutions have seen the profits made by insurance companies and want in on the action. Insurance deductibles on outstanding balances are offered by credit card companies and banks. This usually amounts to a few dollars per month, and if you die, the policy will pay off that debt in full. If you choose this coverage from a lending institution, make sure to subtract that debt from any life insurance calculations you make; being doubly insured is an unnecessary cost.
What Is a Rule of Thumb for How Much Life Insurance You Need?
There are several rules of thumb you can use to figure out how much life insurance you'll need. These frequently entail multiplying your current income by a number such as 10x or the number of years until retirement. Other general guidelines include totaling all expenses and obligations for your family.
Is Life Insurance Needed After Age 60?
While life insurance is typically purchased to replace the economic loss of someone who has a family to support in the event of their untimely death, it can also be purchased by those whose children have grown up. This can be done for a variety of reasons, such as passing on an inheritance, establishing a trust upon death, donating to a charity, or if the elderly person is a key employee or partner in a business.
Nonetheless, many insurance companies only offer term policies to people between the ages of 18 and 65. However, depending on the insurer and policy, you can get coverage started as late as age 80. However, keep in mind that life insurance premiums rise as you get older when you buy the policy.
What Happens to My Life Insurance if I Lose My Job?
If you lose your job and have private life insurance that you purchased on your own, you will be covered as long as you continue to pay your premiums. If the insurance was provided through your employer as a group plan, you will typically lose that coverage one month after being terminated.
Can I Cash out My Life Insurance Policy?
If you own a cash-value permanent life insurance policy (such as whole life or universal life), you can often borrow against or withdraw some or all of the value. The death benefit will typically decrease in proportion to the amount you withdraw from the policy. You will lose all of your coverage if you surrender the entire amount.
The Bottom Line
If you require life insurance, you must first determine how much and what type you require. Most people can get by with renewable term insurance, but you should consider your specific situation. If you decide to buy insurance through an agent, decide on what you'll need ahead of time to avoid being stuck with insufficient coverage or paying for coverage you don't need.
As with investing, educating yourself is critical to making the right decision, so do your homework to ensure you get the best life insurance possible. Find and compare life insurance quotes to see which deal best meets your specific requirements.