How much life insurance do you really need?
The main reason anyone buys life insurance is to help the ones they love, to not struggle financially if they die. It is that simple. If you are considering life insurance, a quick way to determine how much life insurance you need is to take yourself out of the picture financially. If your paychecks stopped how much money would your family need and for how long?
Here is a quick and easy process to help you determine how much life insurance you really need. Collecting a few of your personal financial documents and knowing your annual income will help you. You need copies of the three most recent bank or credit union statements. If you use more than one bank or credit union account to conduct your personal business, you will need three months of statements for those accounts as well.
Each statement will have a total of deposits and withdrawals. If this is not done for you, add each transaction to come up with a total for each statement. Hopefully, you have more deposits than withdrawals. If not, you need to have a budget because you are spending more money than you make. If you are in this situation, you still need life insurance. If you die, who will pay the bills? Nevertheless, the strategy I am outlining will still work for you. You can adjust the length and amount of life insurance in the end.
This process of determining how much life insurance you will need is going to come up with two numbers. One number is going to be the amount of life insurance your family will need to pay all their bills from month to month. This will be the amount that they really need.
The second number is going to be the amount of life insurance that you would like to give your family so they can accomplish all that you had hoped. This is the amount of money that will give them all the dreams and plans that you had for them; a home to live in, education for your children, and a secure financial future. This strategy is not going to ask specifics about your plans for your family. I am going to assume that the income you are making would take care of all the financial hopes and dreams your family would have.
To begin, let us work with the amount that your family will need. Take the total of monthly withdrawals divided by the number of statements you are using and then multiply that number by twelve. Here is an example:
October withdrawals = $2,342
November withdrawals = $2,895
December withdrawals = $3,698
Total withdrawals = $8,935 / 3 months = $2,978.33
Monthly average x 12 = $35,740 average yearly expense.
Depending on how many people are in your family then reduce the yearly average by the percent that you represent. For example, 1 out of 3 would be 33%. 1 out of 4 would be 25%. Take the percent that you represent and subtract that from your yearly average.
Let us say that you represent 25% of your family’s yearly expense. $35,740 - $8,935 = $26,805. $26,805 is the amount of money that your family will need to pay the monthly expenses if you die. The next question to ask is how many years do you think that number will be needed? The basic answer is arrived at by considering the age of your youngest child. Let us assume that they live at home until they are twenty-six. You can change that number if you want. Using the age twenty-six would mean that to help your family pay their average monthly expenses until your youngest child leaves home would require $26,805 a year for eighteen years or $482,490.
Many life insurance companies use a process of pricing called banding. With most life insurance companies, if you round the amount of life insurance up to the $500,000 level, you will reach a band where the price per dollar is less. The best policy for covering just your family’s expenses for eighteen years would be a twenty-year level term life insurance policy. If you are technically inclined, you may see that your need for life insurance will go down over the years. However, because of the type of life insurances that are on the market, one policy for twenty years would be your best value. If we can have a conversation over this subject, I will be glad to go into more details if you like.
As an example, if a 35-year-old husband wanted to buy a twenty-year term policy to cover half a million dollars of life insurance, the cost would be approximately $21 per month or $240 per year.
35-year-old husband in good health
$500,000 twenty-year level term life insurance
≈ $21/month
Now let us look at the second number, the one that includes all of your family’s financial hopes and dreams. The second number is going to work to only replace your annual income. You can adjust the number of years to produce the income, however for this example, we are going to use eighteen years again. Take your annual income and subtract the amount that would represent you. You will recall in the previous example that was $8,935. Let us assume that your annual income is $50,000. Subtract $8,935 and that leaves $41,065. That number for eighteen years would be $739,170.
To get to the next discount band for life insurance, you would look for a twenty-year term life insurance policy with a $750,000 death benefit. Using the same assumptions in the previous example, a 35-year-old husband in good health, the cost would be approximately $30.19 per month or $349.00 per year.
35-year-old husband in good health
$750,000 twenty-year level term life insurance
≈ $30.19/month
For each of these examples, the amount needed will be low because inflation was not taken into consideration. Here is a simple way to approximate the impact of inflation. Remember that inflation is the rate at which the price of goods goes up. A good number to use for inflation is 3%. Using a simple rule called the rule of 72 will help you approximate the effects of inflation. Take any interest rate and divide it into 72 and it will determine the number of years for a value of something to double. For example, if you buy an item for $10.00 today and the price goes up 3% a year, it will take 24 years for that price to double. 72/3=24.
So, what does this have to do with the amount of life insurance you need in the example? If the husband in the example died today, the amount of money to support his family would increase by 3% per year. Replacing the $41,065 income that increases by 3% annually for inflation would require $961,513.79. Bottom line, this example would be better off with a life insurance policy of $1,000,000.
35-year-old husband in good health
$1,000,000 twenty-year level term life insurance
≈ $36.69/month
I have not mentioned any specific life insurance company. However, the companies used are all financially healthy companies that are well rated by rating services such as A.M. Best, Moodys, and Standard & Poors.
If you need help in figuring out how this strategy would work for you, please feel free to contact me at 713-320-6124 or by email at van@advice4lifeinsurance.com
By Van Richards
Van is the founder of Advice4LifeInsurance and Advice4Retirement. You can contact him at van@advice4lifeinsurance.com Follow on Twitter @VanRichards or Facebook at https://www.facebook.com/advice4lifeinsurance/ and https://www.facebook.com/Advice4Retirement/