How to figure out how much life insurance coverage we need is quite simple.
This process depends on the situation so today we will look at a common example of buying life insurance for a family.
The easiest way to look at this is to go through an example. Let's use Peter and Mary-Lou as our example. Their details are as follows;
Peter - 40 yr. old non-smoker - Earns $75,000 per year.
Mary-Lou - 40 yr. old non-smoker - Stay at home mom
Kristy- 5 yrs old - Daughter
Jared - 3 yrs old - Son
We sit down, Peter and Mary Lou say, "We need to buy life insurance and we are not sure how much we should get, what do we do?"
Well I said, "the first thing we need to look at is what's called Our Immediate Cash Needs"
Immediate Cash Needs
FIrst off, I ask Peter and Mary Lou, "do you have a mortgage or any debts outstanding?" (personal loan, line of credit, credit cards, etc.)
They said yes...
Mortgage - $200,000
Line of Credit - $10,000
Next we look at final expenses which include things like funeral/burial, final tax return, any legal work, etc.
This can range anywhere from $8,000 to $80,000.
In their case they said let's put $15,000 towards this.
We then ask, "is it important to you that you provide money for your children's education?"
They said yes, absolutely we would like to help them by providing $20,000 each ($5000 for 4 years each child)
Finally, in the financial planning world we suggest a family should have around 3 - 6 months' salary saved in order to fund an emergency such as to fix a roof, car etc.
They agreed that this is important to them, and they would like to have $30,000 in an emergency fund. (about 3 months of joint family income)
So Lets add this up;
Total Debts - $210,000
Final Expenses - $15,000
Education Savings - $40,000
Emergency Fund - $30,000
Total Immediate Cash Needs = $295,000
So if something were to happen to Pete or Mary-Lou there would be enough money to - Pay off all debts, provide for all costs of death, have some money for the kids schooling, and a rainy day fund.
Some people would say this is all the insurance we need but the answer is no, the most important need of life insurance is for our continuous cash needs.
Continuous Cash Needs
Now to figure this out it is a little trickier, we need to use a Rate of Return to figure out how much of a lump sum we would need to provide an income every year to replace Peters income.
We need to figure out what rate of return in interest we could earn and what inflation will be. This is easier said than done so let's look at a few examples.
If we could earn 5% on our money and inflation is 2% our total rate of return is 3%.
Peter's income = $75,000
Peter's Income / 3% = 2.5 million dollars
Peter's income / 5% = 1.5 million dollars
Peter's income / 7% = 1.1 million dollars
So, if we had this much money in a lump sum and could earn these rates of return every year we would be able to match Peter's income without touching our capital.
In reality rates of returns would fluctuate, and our capital would fluctuate.
Often at this point people say to me "listen, I don't really get what your talking about. Your talking about rates of return, inflation, and there's all these different variables, is there any easier way to do this?"
The answer is yes...A couple.
How long until my youngest kid is 25?
One way I like to do this is by looking at how long it takes until our youngest child reaches 25. Age 25 is about the average age children are leaving the household these days, so if we could replace our income until our kids are out of the house this would make most people happy.
In the above example their son Jared is 3. So if we took Paul's income ($75k) x 22 yrs. we would get 1.65 million dollars. So if something happened to Paul, Mary-Lou would have enough money to continue life as is, and if something happened to Mary-Lou, Paul would be able to stop working and take care of the family or hire help.
Some people also like to use online calculators to figure out how much insurance they should get. Here are a couple I have come across;
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