Shopping around for life insurance products is about more than just finding which insurance company offers the cheapest policy. If you want to buy life insurance, you need to be able to make an informed decision about how much life insurance to purchase to ensure the right amount of financial support for your family. A life insurance needs analysis is how you make that determination.
There are ways for you to purchase more life insurance coverage later on, so for now you don’t need to feel pressured to land on the perfect number, but you should have a good estimate of how much life insurance coverage is right for you and your family before making a purchase.
Calculating Life Insurance Needs
There are different ways to approach calculating your life insurance needs. To get a good ballpark figure of how much life insurance you might need, you can start with some common rules of thumb like the “10x rule” or the “DIME method” of calculating how much insurance you need.
You may also be able to find life insurance calculators or other such online resources that can help you get a more granular understanding of how your specific circumstances and financial obligationstranslate to a comprehensive life insurance needs analysis.
Finally, it can be a good idea to talk to a life insurance agent or financial professional to seek further guidance. For now, let’s review some of the basic baseline calculating methods.
10x Rule
The 10x rule is simple: you take your current annual salary and multiply it by 10. The resulting number is how much life insurance you should buy. So, for instance, if your annual income is $50,000, you should purchase a life insurance policy with a coverage amount of $500,000.
This is a good starting point if you have dependents—like children or a spouse who doesn’t work—who depend heavily on your income for their survival and wellbeing. The idea is that this amount of coverage would provide your family members with the income you would have earned over the next 10 years. This can buy them enough time to come up with a plan for replacing your lost income in the long term, and could serve as income replacement beyond those 10 years, possibly even for the rest of their lives, if the money is invested wisely.
However, the 10x rule might not be right for everyone. Each life insurance company has a maximum amount of coverage they will offer on their policies. Some may not offer policies with coverage amounts equal to 10x your income, and if they do, they may be harder to qualify for than a policy with a lesser coverage amount.
DIME Method
Another limitation of the 10x rule is that it only takes into account one factor: your income. In reality, most people leave behind much more than a loss of income when they die.
The DIME method is a tool for calculating life insurance that assesses a wider range of financial obligations, goals, needs, and considerations: debt (D), income (I), mortgage (M), and education (E).
Debt
Unfortunately, debts do not go away when you die. If you have unpaid credit card debt, student loans, car loans, or other debt, those financial burdens will fall to your surviving family members.
The death benefit from a life insurance policy can help to ease these burdens, which is why debt is an important part of a life insurance needs analysis that varies across individuals and families.
Income
Income is still an important component of life insurance needs analysis with the DIME method. The loss of lifelong expected income resulting from your death imposes a huge financial strain upon your surviving family members.
You want to make sure that the death benefit from your life insurance coverage can replace at least some of that income. Depending on your means and your family’s needs, you may decide that 10x your current salary is not enough or you may find the opposite is true: that 10x is an excessive amount, and you’d rather purchase a more affordable policy. For instance, if your spouse works, their life and the lives of any dependent children you might have, would certainly be financially impacted by the loss of your income. But there would still be some household income remaining.
In this case, you may not need to provide your family with 10+ years of income replacement. Maybe you only need to buy your spouse one or two years worth of additional income so that they can grieve without rushing back to work, have time to search for and pick up more work if necessary, and pay off debts and final expenses.
Mortgage
If you own a home, your mortgage payments can be quite expensive. Calculating the total amount of money needed to pay off your remaining mortgage payments is a wise part to include in your life insurance needs analysis. One of the worst things that can happen if you die unexpectedly is for your family to be unable to pay these mortgage payments, in which case they could lose their house.
Education
If you have children, another costly expense can be education, especially college tuition, which typically costs tens of thousands of dollars per year. The death benefit payout from your life insurance policies can ensure that your children’s current college education is uninterrupted or that their future ability to attend college is not thrown into jeopardy.
There might even be education costs tied to income replacement. For instance, if your spouse doesn’t work and all of a sudden has to start a career to make up for the loss of your expected income, they may need to go back to school to gain the credentials necessary to land a good enough job to provide for themselves and your children.
Other Expenses and Considerations
The DIME method will help you gain a clear, comprehensive picture of some of your family’s most significant financial obligations and needs, but there are still a few other important expenses to consider.
Final Expenses
Final expenses, such as burial and funeral costs, can be quite expensive and easy to neglect. Even if you can’t afford a life insurance policy that will replace your income, pay off your debts, and cover other major long-term expenses like mortgage payments and college tuition, having a lesser amount of life insurance can still be tremendously helpful in covering these costs, which represent both a financial and emotional burden on your surviving loved ones.
Emergency Fund
So far, we have only discussed your family’s expected financial needs and obligations. But life comes with all sorts of unexpected twists and turns. If you really want to round out a comprehensive plan for ensuring your family’s future financial security, it’s important to also consider how your life insurance coverage can allow for the creation of an emergency fund.
In contrast to the money your family members might need to use immediately to pay things like final expenses, outstanding debts, and short-term income replacement, an emergency fund will provide them with a financial cushion to protect against costs associated with unforeseen circumstances, such as medical expenses and other unpredictable future expenses.
Even basic daily living expenses can go overlooked, so determining the amount of life insurance needed is a matter of looking at a comprehensive picture of future needs.
Future Financial Goals
Consider future financial goals in your life insurance needs analysis as well. Maybe you don’t own a home now, but you would like to one day be able to buy a home for your family. Maybe your kids are still very young, but you want to have a plan in place for college funding in the future. Or, you may consider other loved ones, like aging parents, who may have funeral expenses or other costs on the horizon.
Having goals and additional considerations like this built into your life insurance calculations can ensure the possibility of meeting such goals remains alive even after the financial loss associated with your passing.
Who Can I Talk To?
As you can see, there are a lot of financial factors to consider when calculating your life insurance needs, but you don’t need to tackle this process all on your own. Knowing who to talk to can make the life insurance needs analysis feel less daunting.
Family
First, start by talking to your family members. Make sure you’re all on the same page about what your financial goals are and what a plan for future income and financial protection might look like if you were to die unexpectedly.
Financial Advisor
A financial advisor can be a very helpful resource if you don’t exactly know how much money you need to meet certain financial goals like paying for college or buying a house. Financial professionals have a good sense of your family’s current living expenses and how life insurance can function as an important piece in the puzzle of your family’s full, lifelong financial journey. A tax advisor can also be useful in a similar way.
Life Insurance Agent
Finally, a life insurance agent will have access to crucial information that you and your advisors might not have: a full understanding of the details of the policies they can offer you. Talking to an agent about your unique life circumstances will position the agent to make proper recommendations about which insurance products might work best for you (whole life insurance, universal life insurance, or term life insurance), as well as how much coverage you may need.
