Life insurance is one of those things that we would rather not have to think about. It reminds us that life is finite, and that no matter how careful we are with our driving, our health, our habits, etc. we only have limited control over when we die. It’s a rather sobering thought.
Even more sobering is the thought of leaving your family to deal with the financial aftermath of it all if you don’t have life insurance. Here is where the questions start and what today’s post attempts to answer. Generally, there are four primary questions regarding life insurance:
– Who needs life insurance?
– Why do I need life insurance?
– What kind of life insurance do I need?
– How much life insurance should I have?
Before getting into the answers, it helps to define what exactly life insurance does. Basically, when you purchase a life insurance policy you enter into a contract where you agree to pay a certain dollar amount (called a premium) every month/quarter/year in exchange for a certain dollar amount (called the face value) when you die. Insurance policies generally exclude death due to suicide, acts of war, and other things, but every policy is different. Be sure to read the fine print.
Who needs life insurance?
The purpose of life insurance is to protect against loss of income when a person dies. Depending on your individual life situation, you may or may not need life insurance. For example, a single person with no dependents probably doesn’t need life insurance (or at least only a small amount to cover funeral expenses). In this case, there is no surviving spouse or children that need your income to provide for them. But if you have anyone that relies on your income for support, you need life insurance.
In general, you probably need life insurance if:
– You are married
– You have children
Why do I need life insurance?
As I mentioned above, life insurance is to protect against loss of income. Using myself as an example, my income is super important to my family. We are a single income household, with my wife staying at home to take care of our son. If I were to die, they would absolutely need to replace my income. We have a mortgage on our house, we have an automobile loan, and we have Tyler’s college to help pay for. And all of these things are beside the fact that it takes money to buy groceries, pay the bills, and have a little fun every so often.
Everyone’s situation is different. Maybe both you and your spouse work, and you have no children. But maybe your mortgage is too large for your spouse to handle with only their income if you were to die. Maybe you’re a single parent with children. Should something happen to you, your life insurance could provide for your children. Or maybe you just want to leave your spouse or children a pile of money if you die. The point is that most people need life insurance to some extent. You may not need enough to replace your entire income for 40 years, but you need something.
What kind of life insurance do I need?
There are two primary types of life insurance: term and whole life. The difference is that term life insurance, as its name implies, is only effective for the term of the policy. You can get terms as short as 5 years to as long as 35 years. So, if you die within your policy term, your beneficiary receives the face value of your insurance policy. If you die after the term expires your beneficiary receives nothing, as the policy is no longer active. Term life insurance generally offers the lowest rates, and is generally the type of insurance most people should have. Whole life insurance is effective until death, so you don’t have to worry about out-living the term of your insurance policy. However, the premiums for whole life insurance are higher than for term life insurance.
Personally, I purchased a 30-year term policy for several reasons. After 30 years, our son (and maybe other children) will have grown into independent adults and will no longer need my income for support. After 30 years of regular contributions, our retirement fund will be sufficient to provide for my wife’s needs.
A lot of insurance agents get paid (at least partially) on commission based on the annual premiums of the policies they sell. As such, there is an incentive to recommend whole life policies that cost more, but that most people don’t really need. Stick to your guns and go with term life insurance.
How much life insurance should I have?
There is no one answer to this question. A lot of times you’ll hear guidelines saying that you need 8 to 10 times your annual salary as life insurance, but that is a VERY general rule. It doesn’t take into account your personal situation, which may indicate that you need either more or less than that. Here are a few steps to figure out how much you really need.
1. Add up all debt you want paid off if you die.
For us as a one-income household, I would want our mortgage and car loan paid off. Having those two monthly payments gone would be a huge help to my wife and son. (Total insurance need: $120,000)
2. If you have children, estimate how much they’ll need for college.
Education is very important to us, and we want to make sure that if something happened to me that Tyler would still be able to afford college. The difficulty here is figuring out how much tuition and housing will be 18 years from now. A good guess is that rates will keep rising around 5% a year. So, if I figure a year’s tuition, housing, and books at a good state university right now is around $20,000, I should plan on just over $200,000 for his four years of college.
3. Figure how much income will need replaced for your spouse/children to live on
This is the most difficult part and can vary widely depending on your situation. In a two-income household, you may not need to replace as much of your income. Personally, our thoughts were that we wanted enough to replace my entire income until our son was in school (when my wife would re-enter the workforce) and then replace half my income from then until Tyler was 18. One thing to point out is that we included retirement savings as an expense in these figures. So, my wife would still be contributing to the retirement fund all this time. (Total insurance need: $500,000)
As a side note, I think very highly of my wife and have no doubt that if I die, it won’t take long for a line of suitors to come after her. And if she re-marries, our life insurance need would be less.
I know that over the 30-year term of this policy, things can change. We could have additional children. Our debts will gradually become lower. The longer I live, the fewer years of income replacement will be necessary. Life insurance is not an exact science. There’s no way to know what your exact needs will be 10 years into the term, but getting a good ballpark figure when you start helps out. If our insurance needs change dramatically in the years ahead, I can purchase an additional policy.