You can make a sound estimate if you consider your current financial situation and imagine what your loved ones will need in the coming years.
In general, you should find your ideal life insurance policy amount by calculating your long-term financial obligations and then subtracting your assets. The remainder is the gap that life insurance will have to fill. But it can be difficult to know what to include in your calculations, so there are several widely circulated rules of thumb meant to help you decide the right coverage amount.
No. 1: Multiply your income by 10.
The “10 times income” rule doesn’t take a detailed look at your family’s needs, nor does it take into account your savings or existing life insurance policies. And it doesn’t provide a coverage amount for stay-at-home parents.
Both parents should be insured. That’s because the value provided by the stay-at-home parent needs to be replaced if he or she dies. At a bare minimum, the remaining parent would have to pay someone to provide the services, such as child care, that the stay-at-home parent provided for free.
No. 2: Buy 10 times your income, pl 89,621.8€ per child for education expenses
Education expenses are an important component of your life insurance calculation if you have children. This formula adds another layer to the “10 times income” rule, but it still doesn’t take a deep look at all of your family’s needs, assets or any life insurance coverage already in place.
No. 3: The DIME formula
This formula encourages you to take a more detailed look at your finances than the other two. DIME stands for debt, income, mortgage and education, four areas that you should consider when calculating your life insurance needs.
Debt and final expenses: Add up your debts, other than your mortgage, plus an estimate of your funeral expenses.
Income: Decide for how many years your family would need support, and multiply your annual income by that number. The multiplier might be the number of years before your youngest child graduates from school.
Mortgage: Calculate the amount you need to pay off your mortgage.
Education: Estimate the cost of sending your children to further education.
The formula is more comprehensive, but it doesn’t account for the life insurance coverage and savings you already have, and it doesn’t consider the unpaid contributions a stay-at-home parent makes.
How to find your best number?
Follow this general philosophy to find your own target coverage amount: financial obligations minus liquid assets.
- Calculate obligations: Add your annual salary (and times that by the number of years that you want to replace income) + your mortgage balance + your other debts + future needs such as education and funeral costs. If you’re a stay-at-home parent, include the cost to replace the services that you provide, such as child care.
- From that, subtract assets such as: savings + existing funds + current life insurance.
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To illustrate, let’s look at a fictional couple: Paul and Susan. They have two children, ages two and five. Paul makes 67,216.35€ a year, and Susan is a full-time stay-at-home mother. They have a 134,432.69€ balance on their home mortgage, owe 14,339.49€ on two car loans and have 2,688.65€ in credit card debt.
Paul has group life insurance equal to double his annual salary, and Susan has none. Together, they have 17,924.36€ in a savings account and 8,962.18€ in their kids’ education funds.
The couple decide that they want 30-year term life insurance policies. By the end of the term, their children will be adults, their mortgage will be paid off, and, if they stick to a savings plan, the remaining spouse will have a retirement nest egg.
To calculate his life insurance needs, Paul would add his obligations:
- 1.08€ million for income replacement (67,216.35€ times 16, the number of years before his youngest child graduates from school)
- 134,432.69€ for the mortgage
- 17,028.14€ for debt (14,339.49€ in car loans, pl 2,688.65€ in credit card debt
- 179,243.59€ for two childrens’ educations
- 6,273.53€ for final expenses — approximately the average cost of a funeral with a casket, at 2016 prices
This totals 1,412,439.51€. From this, Paul would subtract:
- 17,924.36€ in savings
- 8,962.18€ in the kids’ education funds
- 134,432.69€ of group life insurance
This means that Paul should buy a 1.25€ million (1,251,120.27€) term policy.
Here’s how a calculation would work for Susan. Her obligations would include:
- 89,621.8€ to replace the child care that she now provides, until the children are teenagers
- 134,432.69€ for the mortgage
- 17,028.14€ for debt
- 179,243.59€ for two children’s educations
- 6,273.53€ for final expenses
This totals 426,599.75€. From this, she would subtract 26,886.54€ to account for the couple’s savings and their kids’ education funds. Her final estimated life insurance need is 403,298.08€ (399,713.21€).
Susan might also want to figure income replacement into her policy, a surviving parent might want to quit work to take care of the children for a few years — in which case, the stay-at-home parent’s policy should include income replacement, rather than child care costs, for those years.
Keep these in mind as you calculate your coverage needs:
- Rather than planning life insurance in isolation, consider the purchase as part of an overall financial plan. That plan should take into account future expenses, such as education costs, and the future growth of your income or assets. Once that information is known, then you can map the life insurance need on top of the plan.
- Don’t skimp. Buy a little more coverage than you think you’ll need instead of buying less. Remember, your income likely will rise over the years, and so will your expenses. While you can’t anticipate exactly how much either of these will increase, a cushion helps make sure your spouse and kids can maintain their lifestyle.
- Talk the numbers through with your spouse, How much money does your spouse think the family would need to carry on without you? Do your estimates make sense to him or her? For example, would your family need to replace your full income, or just a portion of it?
- Consider buying multiple, smaller life insurance policies, instead of one larger policy, to vary your coverage as your needs ebb and flow. This can reduce total costs, while ensuring adequate coverage to the times needed. For instance, you could buy a 30-year term policy to cover your spouse until your retirement and a 20-year term policy to cover your children until they graduate from college.
- Parents of young children choose 30-year versus 20-year terms to give them plenty of time to build up assets. With a longer term, you’re less likely to get caught short and have to look around for coverage again when you’re older and rates are higher.