Given my recent responsibilities of new children and having now moved into a more permanent home, I’m turning my thinking to planning for any unfortunate accidents.
I’m attacking this from several fronts, including preparing a will & testament, an emergency guide to our family’s finances and my personal information, and purchasing some kind of financial protection for my family in the form of life insurance.
Getting life insurance if you’re relatively young and healthy is neither expensive nor difficult, but there is one important question that you have to answer before you shop, or someone without your best interest at heart will answer it for you. It’s how much insurance to get!
Term vs. Whole Life
Life insurance comes in two basic varieties: term and whole. In basic terms, term life is an insurance you get for a set period of time (most commonly 20 or 30 years) to cover the period of time where your family is relying on income the most. Whole life insurance is an investment, and is more complicated to evaluate and choose if you go down this road.
Most unbiased financial advisors and other people I trust recommend term life, since they say whole life insurance can be a poor investment. Since that decision was easy for me, the question of how much to get remains.
I’ll share the thought process I used to arrive at the total. The numbers are not my own, but the way I got to the end is the same.
What am I Protecting?
The basic purpose of life insurance is to protect my family’s income. Since I’m the sole provider for my family, if something were to happen to me, my family would be without income. A life insurance policy needs to provide enough cash flow to fill my family’s needs for as long as I think they will need it. Let’s look at that in more detail:
Let’s use round numbers and assume I make $100,000 per year. I also own a home and have the following family debt (we’ll also use round, arbitrary numbers);
- $250,000 mortgage
- $50,000 in student loans
- $20,000 in car loans
That comes to $320,000 in total family debt, which is a big part of the monthly obligations the family needs to meet. It’s also why a lot of insurance advisors will start their calculations assuming that the life insurance policy will pay off all or most of these debts. No big debts means no big monthly payments.
So let’s start there–$320,000 will go toward wiping the slate clean.
Now, recall that I assumed I make $100,000 a year, and let’s also assume that 40% of this (or $40,000) goes toward debt, which is a debt-to-income ratio that’s common for many families. Let’s also assume that, at the current income, we’re saving about $30,000 a year that goes directly into savings.
That leaves about $30,000 that is earmarked for non-debt expenses of the family. Should I die and all the debt is wiped clean, the family will still need $30,000 per year for common expenses.
We have a yearly figure, but for how long will this need to last? For example, will my wife decide to take on a job to cover some of these expenses? Will the expenses fall or rise in future years?
Realistically speaking, we could have another 35 years until retirement age. It’s unrealistic to think that the income will never be replaced, especially since my kids will all be in college in another 15-20.
If we assume total replacement of “true expense” income for 15 years, that adds $450,000 to the policy. If we consider that the likelihood of my death is low at my age, I think 10 years of income, or $300,000 is more realistic for the length of the policy we’ll get (most likely 20 years).
There are a few other things left to be considered. First, will my children go to college and will they need financial help when they do so? Without steady income, it will be tough for the family to save for these costs on their own.
We’ve decided that the life insurance policy will need to cover the amount that we would have realistically saved by the time the kids go to college. For the sake of argument, let’s say this is $100,000.
The other consideration is whether there will be medical and burial costs associated with my early demise. Given that we have adequate health insurance, we should be buffered against any unexpected medical bills, but between all the deductibles and the additional costs for travel and burial, lawyers, accountants, and anyone else the family might need to hire, let’s allocate another $30,000 for this purpose.
Totalling it Up
Let’s add up everything we’ve considered so far:
- $320,000 to pay off all major debts
- $300,000 to cover expenses for about 10 years
- $100,000 for college
- $30,000 for “final” expenses
Grab your calculators and we get a total of $750,000. If these were my own numbers, I would feel comfortable getting a quote for a 20-year policy for $750,000 and knowing that my family would be okay if anything happened.
Of course, there are a lot of ways to arrive at your own total, but my advice would be not to trust the rules of thumb the insurance industry will give you, but to really look at your own life situation instead, anticipating how it might change over the life of the policy as well.