How Much Life Insurance Should You Carry?

[Investopedia]

Death, just like taxes, is inevitable. We all have to go at some point—it’s something we just can’t avoid. When it comes to death, most of us probably aren’t that keen to think about the end. Maybe it’s because we don’t want to think about what we’ll leave behind for their loved ones, which may simply be a big donut—nothing at all. But others are better prepared, thinking about the income their loved ones may miss, and need, after they die. That’s where life insurance comes into play. It’s a way to make sure those who depend on you are taken care of after you die. Although it may sound unpleasant, it is something we all have to consider. In this article, we look at life insurance. First, we’ll point out some of the misconceptions, then we’ll look at how to evaluate how much and what type of life insurance you need.

KEY TAKEAWAYS

• Your financial and family situation will determine whether you need life insurance.
• The younger you are the lower your premiums, but older people can still get life insurance.
• Carry as much as you need to pay off your debts plus any interest.
• Your policy’s payout should be large enough to replace your income plus a little to hedge against inflation.

What Is Life Insurance?

Before we answer this question, it’s important to know what exactly life insurance is. Life insurance is an agreement wherein an insurance company agrees to pay a specified amount after the death of an insured party as long as the premiums are paid and up to date. Policies give insured persons the assurance that their loved ones will have peace of mind and financial protection after their death.

Life insurance falls into two different categories—whole and term. Some provide you with a cash value, taking the premiums you pay and investing them into the market, while others only pay out if you die within a certain time period. Some policies allow you to renew your coverage after a certain expiry date, while others require a medical exam. Sure, it’s a lot to digest, but it’s definitely something you should discuss with your family and your insurance agent. Before you do that, you’ll have to figure out if insurance is the right thing for you.

Who Needs Life Insurance?

Life insurance sounds like a great thing. But buying a policy doesn’t make sense for everyone. If you’re flying through life solo and have no dependents with enough money to cover your debts as well as the expenses related to death—your funeral, estate, attorney fees, and other expenses—you’re probably better off without it. After all, why bother with the extra expense if you’re not going to reap the benefits? The same applies if you have dependents as well as enough assets to provide for them after your death.

But if you’re the primary provider for your dependents or have a significant amount of debt that outweighs your assets, insurance can help ensure your loved ones are well taken care of if something happens to you.

The Age Factor

One of the biggest myths aggressive life insurance agents perpetuate is that if you’ve missed the boat if you fail to sign up for a policy when you’re young. The industry leads us to believe that life insurance policies are harder to get the older you become. Insurance companies make money by betting on how long people will live. When you are young, your premiums will be relatively cheap. If you die suddenly and the company has to pay out, you were a bad bet. Fortunately, many young people survive to old age, paying higher premiums as they age. That’s because the increased risk of them dying makes the odds less attractive.

It’s true that insurance is cheaper when you are young. But that doesn’t mean qualifying for a policy is easier. The simple fact is insurance companies want higher premiums to cover the odds on older people, but it is very rare that an insurance company will refuse to cover someone who is willing to pay the premiums for their risk category. That said, get insurance if you need it and when you need it. Do not get insurance because you are scared of not qualifying later in life.

Is Life Insurance an Investment?

You may be one of those people who consider life insurance to be an investment. Well, you may think differently when you compare it to other investment vehicles, even if some policies invest your premiums and promise you a portion of the policy’s value in cash.

Cash-value policies are generally touted as another way to save or investing money for retirement. These policies help you build up a pool of capital that gains interest. This interest accrues because the insurance company is investing that money for its own benefit, much like banks. In turn, they pay you a percentage for the use of your money.

Life insurance isn’t always a great way to invest. If you take the money from the forced savings program and invest it in an index fund, you’d likely see much better returns. For people who lack the discipline to invest regularly, a cash-value insurance policy may be beneficial. A disciplined investor, on the other hand, has no need for scraps from an insurance company’s table.

If you’re banking on using a life insurance policy as a substitute for regular investments, do your homework because you may do better putting that money into the market.

Cash Value vs. Term Life

Insurance companies love cash-value policies and promote them heavily by giving commissions to agents who sell them. If you try to surrender the policy—i.e. demand your savings portion back and cancel the insurance—an insurance company will often suggest that you take a loan from your own savings to continue paying the premiums. Although this may seem like a simple solution, the loan amount is subtracted from your death benefit if it’s not paid off by the time of your death.

Term insurance is insurance pure and simple. You buy a policy that pays out a set amount if you die during the period to which the policy applies. So if you have a term life policy that expires in 40 years, and you die in 35, your beneficiary gets the death benefit. But if you don’t die, you get nothing. The purpose of this insurance is to hold you over until you can become self-insured by your assets. Unfortunately, not all term insurance is a good fit. Regardless of the specifics of a person’s situation, most people are best served by renewable and convertible term insurance policies. They offer just as much coverage, are cheaper than cash-value policies, and, with the advent of internet comparisons driving down premiums for comparable policies, you can purchase them at competitive rates.

The renewable clause in a term life insurance policy allows you to renew your policy at a set rate without undergoing a medical exam. This means if an insured person is diagnosed with a fatal disease just as the term runs out, he or she will be able to renew the policy at a competitive rate despite the fact the insurance company is certain to have to pay a death benefit at some point.

The convertible insurance policy provides the option to change the face value of the policy into a cash-value policy offered by the insurer in case you reach 65 years of age and are not financially secure enough to go without insurance. Even if you are planning on having enough retirement income, it is better to be safe, and the premium is usually quite inexpensive.

Evaluating Your Insurance Needs

A large part of choosing a life insurance policy is determining how much money your dependents will need. Choosing the face value—the amount your policy pays if you die—depends on a few different factors.

Your Debt

All your debts must be paid off in full, including car loans, mortgages, credit cards, loans, etc. If you have a $200,000 mortgage and a $4,000 car loan, you need at least $204,000 in your policy to cover your debts. But don’t forget the interest. You should take out a little more to settle any extra interest or charges as well.

Income Replacement

One of the biggest factors for life insurance is to replace income. If you are the sole provider for your dependents and bring in $40,000 a year, you will need a policy payout that is large enough to replace your income plus a little extra to guard against inflation. To err on the safe side, assume that the lump sum payout of your policy is invested at 8%. If you do not trust your dependents to invest, you can appoint a trustee or select a financial planner and calculate his or her cost as part of the payout. You will need a $500,000 policy just to replace your income. This is not a set rule, but adding your yearly income back into the policy ($500,000 + $40,000 = $540,000 in this case) is a fairly good guard against inflation. Once you determine the required face value of your insurance policy, you can start shopping around. There are many online insurance estimators that can help you determine how much insurance you will need.

Insuring Others

Obviously, there are other people in your life who are important to you, and you may wonder if you should insure them. As a rule, you should only insure people whose death would mean a financial loss to you. The death of a child, while emotionally devastating, does not constitute a financial loss because children cost money to raise. The death of an income-earning spouse, however, does create a situation with both emotional and financial losses. In that case, follow the income replacement calculation we went through earlier with his or her income. This also goes for business partners with whom you have a financial relationship. For example, consider someone with whom you have a shared responsibility for mortgage payments on a co-owned property. You may want to consider a policy for that person, as that person’s death will have a big impact on your financial situation.

Other Calculations

Most insurance companies say a reasonable amount for life insurance is six to 10 times the amount of annual salary. Another way to calculate the amount of life insurance needed is to multiply your annual salary by the number of years left until retirement. For example, if a 40-year-old man currently makes $20,000 a year, the man will need $500,000 (25 years x $20,000) in life insurance.

The standard-of-living method is based on the amount of money survivors would need to maintain their standard of living if the insured party dies. You take that amount and multiply it by 20. The thought process here is that survivors can take a 5% withdrawal from the death benefit each year—the equivalent to the standard of living amount—while investing the death benefit principal and earning 5% or better.

Alternatives to Life Insurance

If you are getting life insurance purely to cover debts and have no dependents, there are alternatives. Lending institutions have seen the profits of insurance companies and are getting in on the act. Credit card companies and banks offer insurance deductibles on your outstanding balances. This often amounts to a few dollars a month and, in the case of your death, the policy will pay that particular debt in full. If you opt for this coverage from a lending institution, make sure to subtract that debt from any calculations you make for life insurance—being doubly insured is a needless cost.

The Bottom Line

If you need life insurance, it is important to know how much and what kind you need. Although generally, renewable term insurance is sufficient for most people, you have to look at your own situation. If you choose to buy insurance through an agent, decide on what you’ll need beforehand to avoid getting stuck with inadequate coverage or expensive coverage you don’t need. As with investing, educating yourself is essential to making the right choice.