Consider this: if you were to pass away today, what financial burdens would your family be left with? Your income would disappear, along with everything it pays for – from the essentials like groceries and mortgage payments, to the extras like music lessons and sports gear. Any savings you have might be seized by creditors to settle your debts. And let’s not forget the hefty funeral costs. So, do you have enough life insurance to prevent this scenario?
The amount of life insurance you need isn’t a fixed number. It grows as you take on more debt, start a family, and hit your peak earning years. Then, it starts to shrink as you pay off your mortgage, your kids graduate from college, and you inch closer to retirement. Eventually, you might not need life insurance at all. Your net worth could be enough to support your loved ones after you’re gone, and you might not have any significant debts or financial obligations.
But here’s the catch: life insurance is cheaper and easier to get when you’re young. Ideally, you should buy all the coverage you’ll ever need in your 20s or early 30s, before you actually need maximum protection. This means you have to estimate your future life insurance needs without knowing exactly what the future holds.
Your life insurance needs are a moving target. If you can, consider using a life insurance ladder. This strategy involves taking out multiple policies that add up to the coverage you need, allowing you to gradually reduce your life insurance coverage – and premium costs – over time. This way, you can get cheaper life insurance now and drop policies as you no longer need them, instead of buying new, pricier policies later.
There are several ways to calculate your needs. Choose the life insurance calculation method that best fits your personal situation. Here are a few methods:
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Debt-Protection Method: This method ensures your debts don’t become a burden after your death. You want enough life insurance to pay off any shared debt (like a mortgage, home equity loan, credit cards, car loan) and cover significant future expenses (like your kids’ college tuition). Subtract your assets from your current debts and future expenses to find out how much you need.
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Multiply by 10 Method: This method is great if you know you need a decent amount of life insurance coverage but aren’t sure about your future expenses. Simply multiply your current gross annual income by 10. However, this method might leave you short if you have or expect to have significant debts and expenses, or it might be overkill if your debts and expenses are modest compared to your income or if you have a relatively high net worth for your age.
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Child Buffer Method: Kids are expensive. The child buffer method helps cover the cost of raising your kids to adulthood if something happens to you. It replaces 10 years of your earnings to help your surviving partner or the children’s guardian manage until your children are grown. This method is suitable if you already have kids, share kid-related expenses equally with the other parent, and aren’t overwhelmed by debt and expenses.
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Income Replacement Method: This method aims to replace most of the income you expect to earn for the rest of your career. It doesn’t directly address debt or expenses. This method is best if you’re an older life insurance applicant with a good sense of your likely earning power for the rest of your career.
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Standard of Living Method: This method ensures your survivors don’t have to cut corners after your death. The goal is to get enough life insurance that your surviving partner and dependents can maintain their current standard of living at a safe withdrawal rate.
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DIME Method: DIME stands for "debt, income, mortgage, and education." The DIME method for calculating life insurance coverage accounts for each of these expenses to generate an accurate picture of how much life insurance your family needs.
Remember, life is unpredictable. You need to calculate how much life insurance you need without knowing how things will turn out. The good news is any of these life insurance calculation methods can help you make an educated guess about your life’s trajectory and conservative projections about your income and asset growth in the future. Then, you can decide which is the best term life insurance company for you. And if your assumptions don’t pan out and you find you need more life insurance than you thought, you can always buy more – but the sooner, the better.
