Purchasing life insurance can be a little overwhelming, particularly if you're not sure exactly what you need in a policy. The number one question everyone faces when it comes time to buy a life insurance policy is how much coverage to get.
The following information should help you calculate the right amount for you and your spouse. Every situation is different, so these guidelines aren't set in stone, but they're meant to point you in the right direction. Read also: How Do Cash Value Life Insurance Policies Work?
The Purpose of Your Policy
Life insurance is meant to take care of your family and dependents in the event of your death. Your policy will have to take the place of your income if you want your family to be able to continue their current lifestyle. If you're the main breadwinner in the family, this can sound a little overwhelming. But wait- there's more.
Life insurance can also be used to cover any existing debts that may be left over after death. If you're a small business owner with business debts, or if you have an extended illness, you don't want to leave your family with a pile of bills. Life insurance is designed to help cover those costs, as well as any funeral costs that may incur if you have no other cash available for such an expense.
This might sound like an awful lot, and the truth is, it can be. But believe it or not, most people today are carrying far too much life insurance—thanks in part to pushy salespeople, and thanks in part to their own ignorance.
So even though your life insurance policy needs to cover a lot of things, there's no reason to panic. Read on to get a better idea of what you need. Read also: A Step-By-Step Guide for Buying Life Insurance.
A Basic Life Insurance Calculator
Remember that no one formula can assess your life insurance needs; the situation varies widely from person to person, and taking into account things such as inflation can change your numbers dramatically. But for a very basic idea of what amounts you should be looking at, start here.
Calculate expenses. Make a rough estimate of your family's annual expenses. Include items such as mortgage payments, utility payments, car payments, health insurance, school or college costs, and basic living expenses. If one spouse currently stays at home with the children, consider adding child care costs to your number in case that spouse would be required to go back to work. It may be easiest to estimate these numbers by month and then simply multiply by 12 to get an annual amount.
Calculate other assets. Consider how much money will continue to come into the family in the event of your death. If you and your spouse both work, your spouse's income counts. So does Social Security, savings, or other benefits that the family would incur upon your death. This number will tell you how much money your family will be making, without life insurance, without you.
Check the difference. Place these two numbers side by side, and you'll start to get a rough idea of how much life insurance you might need. How much would your family's financial situation change if you and your income were not there? How much of your income is funding your family's current lifestyle?
Now is also a good time to throw in a few extra thousands of dollars for the cost of a funeral and possible medical bills, unless your family has savings set aside for those things. If not, they'll need to come directly out of your insurance policy, so make sure to tack on those costs as well. Read also: How To Protect Your Retirement Savings With Whole Life Insurance.
If you subtract your expenses from your assets as explained above, you may come out with a negative number if you are the primary breadwinner. In those cases, you'll need more life insurance coverage to ensure your family can continue their lifestyle without any undue hardships.
Although calculating in coverage for disasters is always a good idea, don't go overboard and buy a huge policy on the off chance that something bad will happen and your family will desperately need the extra cash. Keep in mind that their situation will be in flux, and they may need some extra money to get through the adjustment period after a death, but there's no reason to feel you need a policy with an impossibly high amount.
Many people use the "two year grieving period" as a rule of thumb: make sure your family has plenty of cash to fully support them for the first two years after your death, after which time you can assume things will have settled and their financial needs won't be so dire.
If you do find yourself in a situation where your family's finances will be devastated by your loss, but you're anxious about paying huge premiums on a large life insurance policy, consider term insurance. With term life insurance, you can pay into it only for the amount of time when it would be needed- until your kids grow up and become independent, for example. Term allows you to carry a much larger policy with a lower cost to you.