Overview
If you have dependents who rely on your income, like a spouse or young children, life insurance can provide peace of mind. Life insurance provides a financial safety net for your loved ones when you pass away. But just like all types of insurance, simply having life insurance isn’t enough—you need the right amount of coverage in case something happens.
In this article, we’ll explain how to determine how much life insurance you really need, and provide a few formulas for choosing a coverage limit.
The Simple Way to Calculate Your Life Insurance Needs
Calculating your life insurance needs is actually pretty simple. You should choose a coverage limit that will allow your loved ones to continue living their current lifestyle in the absence of your income for a certain period of time.
For most people, this formula is a good starting point: take the total sum of your financial obligations, and subtract your liquid assets. Here’s how to do it.
Start by adding up all of your current financial responsibilities, like your mortgage and outstanding debts, as well as future needs, like college tuition. Then, add your salary multiplied by the number of years you want to replace the income.
Next, find the value of your liquid assets. Your liquid assets include things like personal investment accounts and money in a savings account. Remember that real estate, vehicles, and retirement accounts are not considered liquid assets.
The final step is to subtract the value of your liquid assets from your total financial responsibilities. The number you end up with is the amount of life insurance that you need.
Other Ways to Estimate Your Life Insurance Needs
Manually estimating your life insurance needs is a quick way to get an idea of how much coverage might be sufficient for your situation. But there are a few other formulas that can be used to determine your coverage needs.
Multiply your annual income by 10
If you’re looking for an even faster way of calculating your life insurance coverage needs, you can multiply your annual income by 10. This figure will represent the amount of money you would need to financially support your dependents for 10 years after passing away. So, for example, if your current salary is $100,000, you might need $1 million in life insurance coverage to sufficiently protect your dependents for 10 years.
Multiply your annual income 10, then factor in additional expenses
Multiplying your income by 10 is a good place to start, but it doesn’t account for your specific financial responsibilities. If you anticipate having future financial obligations, a good method is to add a lump sum amount for each additional expense, like mortgage payments, funeral costs, or college tuition. If you’re adding a recurring annual expense, make sure to multiply the amount by 10. For education costs, you should add a lump sum for each child.
Use the DIME formula
The DIME formula is another popular method for getting a detailed estimate of your life insurance coverage needs. DIME is an acronym that stands for debt, income, mortgage, and education, which are the main expenses that you should think about when setting a life insurance coverage limit.
Here’s how to use the DIME formula to calculate your life insurance needs:
Debt: Add up the total amount of debt you have, minus your mortgage. Then, add the estimated cost of your final expenses and funeral.
Income: Determine how long you want to replace your income for. Take your annual income and multiply it by the number of years.
Mortgage: Find the remaining balance on your mortgage.
Education: Figure out roughly how much it will cost to send your kids to college.
The final step is to add each category together to get an overall look at how much life insurance you need. Keep in mind that the DIME method isn’t exact. For example, it doesn’t account for the cost of childcare or the coverage you have from current life insurance policies. You might need to run a few more numbers to arrive at a realistic estimate.
Use an online calculator
If you’re not up for crunching numbers, consider using an online calculator, like the one from Life Happens. You’ll submit some basic information, like how much income you want to replace, how much debt you have to pay off, and how much life insurance you already have. The calculator will automatically determine how much coverage is right for you based on your responses.
Review Your Coverage Needs Regularly
Once you purchase a life insurance policy, it’s important to review your coverage needs on a regular basis. Most people will find that their financial situation changes over time. You might need more life insurance if you get married or decide to transfer your kids from public school to private school, for example.
Reviewing your life insurance needs regularly will ensure that you always have enough coverage in case something unexpected happens. If you need more coverage, you have a few options.
You might be able to increase the death benefit on your current policy, or you can buy another policy. Depending on your situation, you may also find that adding optional riders can fill the gaps in your policy.
by your friends at The Daily Navigator
