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Choosing any number just because it’s convenient to do so is another mistake that consumers often make when buying life insurance. Buying life insurance just because the price is low or simply because one of your relatives advises you to do so will leave your family completely unprotected.
The primary purpose of buying life insurance is to replace the insured person’s income economically. The ideal life insurance amount should cover all your family’s expenses after your sudden death. Life insurance is aimed at protecting your family from financial losses caused by your death.
There are several rules and formulas that can help you calculate the perfect amount of life insurance for your family.
1. The Income Multiple Approach (The Rule of Thumb)
One of the easiest ways to estimate your life insurance needs is the Income Multiple Approach. This approach is designed to provide a general guideline for calculating the minimum financial protection you need to buy.
The Baseline Rule: To provide a decent life for your family, you need to buy the life insurance amount equal to 10-15 times your annual gross income.
The Family Escalation: In case you have small children, have a mortgage for your home, or plan to save some money for your kids’ college education in the future, it’s recommended to increase the amount of life insurance up to 15-20 times your annual income.
Implementation: Let’s suppose you earn $100,000 annually. Using the Income Multiple Approach, we can conclude that the minimum life insurance amount your family needs to buy is between $1 million and $1.5 million. This amount will ensure the income generation for many years ahead.
2. The Human Life Value (HLV) Method
The Income Multiple Approach provides you with the general guidelines for buying life insurance. However, if you want to find the perfect amount of life insurance precisely, you may try to calculate your needs using the HLV Method.
This method assumes that your income capacity is the valuable financial asset that helps your family accumulate wealth. Here’s the formula you should use:
Calculate the amount of your gross annual income.
Subtract your personal expenses (money you spend exclusively on yourself). After your death, there will be no such expenses anymore.
Multiply the obtained amount by the number of working years until your retirement.
For instance, you earn $120,000 per year and spend around $30,000 on your personal expenses. This means that your family receives only $90,000 per year. Now you’re 35 years old and will retire in 25 years (at the age of 60). Multiplying $90,000 by 25, we get $2.25 million. This is the Human Life Value you have.
3. The D.I.M.E. Calculation Strategy
Although the HLV Method will help you find the perfect amount of life insurance, it doesn’t take into account your individual debts or other financial goals you may have. To be 100% sure that your family will remain protected from all possible risks, you should try the D.I.M.E. strategy.
D – Debts
Make a list of all your liabilities. This could include the balance of your credit cards, personal loans, auto financing, line of credit, etc. Exclude your mortgage from this list because it will be considered separately.
I – Income Replacement
How many years will your children need financial support? Multiply this number by your annual salary.
M – Mortgage
You house is both the biggest asset and the biggest liability in your possession. Add the amount of the principal payoff of your home loan to the total sum.
E – Education
Calculate the amount you need for providing your kids with college education. Don’t forget about tuition inflation in the following 18 years. Add the obtained amount to the total sum.
4. The Final Calculation: Subtract Your Current Assets
Now that you know how much money your family will need in case of your death, you are free to deduct the amount of money you’ve already accumulated.
Subtract from the total amount:
The amount of money on your bank accounts (cash savings and emergency funds).
Amount of money on your retirement accounts (like 404k or IRA).
Stable investment portfolios or mutual funds.
Thus, you will determine your family’s actual needs. Suppose you need $2.5 million for your perfect life insurance, but you already have $500,000 on your bank accounts. In this case, you will need to buy only $2 million worth of insurance.
Final Strategy: Buy Early, Keep It Pure
Knowing your target amount of life insurance, the best way to buy such an amount without spending too much is purchasing the Term Life Insurance. This kind of insurance doesn’t require any additional payments associated with the investment structure. Consequently, you will be able to buy Term Life Insurance for millions of dollars while being young for just a few dollars per day.
You should check your life insurance coverage every three or five years. Change your coverage in case of significant life changes like increased salary, marriage, buying a home, having a kid, etc.
Frequently Asked Questions (FAQ)
Question: Is the life insurance offered by my employer enough?
Answer: No, it isn’t. Group life insurance provided by your employer usually covers only 1-2 times your annual salary. However, according to our calculations, you should buy life insurance for 10-15 times your annual income. Moreover, group life insurance depends on your employment; hence, you’ll lose it if you resign from your job for whatever reason.
Question: Does a stay-at-home parent need life insurance?
Answer: Yes, he/she does. Although a stay-at-home parent doesn’t earn salaries and has no other sources of income, this person has great economic value for his/her family. In case you lose your stay-at-home parent, you will have to hire someone to perform all the necessary household work. Hence, the stay-at-home parent should have the amount of life insurance covering these expenses.
Question: Does my age influence the amount of life insurance I can buy?
Answer: Yes, it does. Insurance companies use financial underwriting to make sure you won’t over-insure yourself. They impose certain coverage restrictions depending on your age. For example, individuals younger than 40 years are allowed to buy 25 or even 30 times of their annual income. However, as you get older and closer to your retirement age, this restriction is lowered down to 10-15 times.
Question: What happens when I outlive my term life insurance policy?
Answer: If you chose a 20 or 30-year policy and managed to outlive it, congratulations! Your policy is expired, and you won’t receive any payment. But this is the good news because it means that your family didn’t face any emergency situation during these years. You’ve raised your children, paid off your mortgage and become rich enough to provide your family with life insurance from your savings or investment portfolio.