Life Insurance is a necessity that isn’t always discussed, but is definitely imperative to have. This post will break down the basics of life insurance, the different types of life insurance and how to calculate how much life insurance you need.
For seven years, I worked in the financial planning industry. I helped my clients maintain financial security and grow their wealth. A large chunk of my job was behavior coaching (“this is how you create a budget,” “this is how much you need to save per month if you want to live on this amount of money at retirement”), but the other large chunk of my time was spent educating my clients on the importance of owning life insurance.
What is Life Insurance?
In the most bare bones, no-frills definition, life insurance is a type of insurance contract that pays a benefit after the death of the insured.
When one buys a life insurance policy, either on their life or the life of another (think a parent buying a policy for their child), they pay a premium each month to uphold their end of a contract with the life insurance company. If the insured dies during the terms of the contract, the insurance company will pay out a sum of money that is agreed upon in the contract.
Here’s a basic example: I buy a life insurance policy for $100,000, I pay my bill (premium) every single month and I die tomorrow. My mom and dad (beneficiaries) receive my death benefit (the 100,000).
What are the types of Life Insurance?
There are two main types of life insurance. There is Whole Life (also called Permanent Life) Insurance, and Term Life Insurance. Also, I should mention there are other policies like Universal Life Insurance, Combination Whole and Term Life, Annuities, and Variable Life Insurance, but today, I’m just going to cover the two very basic types. Each of them will pay out if the insured has died, but they all function a little differently when the insured is living. Let’s define each of them.
Whole Life Insurance
Whole life insurance, also called permanent life insurance or cash value life insurance, goes for a person’s whole life. It does not matter if someone dies tomorrow, or lives past 100, the coverage will still be there. While whole life insurance is sometimes considered more expensive, it has a component to it called cash value that term policies don’t have.
What is cash value? Cash value is the premium (or bill you pay) every month subtracting out the expenses of the policy, and then growing like a savings.
Cash Value has a lot of cool benefits. Like I said, it’s a savings within your policy. As you pay premium, the amount of savings you have grows. Some years it grows faster and bigger than others, but with a whole life policy, the value of the savings should never go down.
Term Life Insurance
Unlike Whole Life Insurance that goes for one’s whole life, Term Life Insurance only goes for a term or a length of time. There are many different policies out there for term insurance. Some policies only cover the insured for five years, some cover them for ten years, or twenty, or some cover to an insured’s age like age 65 or 80.
Also different than whole life insurance, term life insurance does not have cash value or savings, so it also has a way lower price tag and premium than whole life insurance. This is the greatest benefit of term coverage; can get a large death benefit for not much premium or a monthly or annual bill.
While the premium initially is much cheaper than whole life insurance, there is a downside to term insurance, or something to look out for. Just like I mentioned before, term insurance goes for a TERM OF TIME. That means once that amount of time passes, you know longer have coverage, and you have to reapply for new coverage. That new coverage will almost always cost more because you are older.
The other thing to look out for is whether your premium is level the entire time you have it, or the premium increases. Here’s my example: let’s say I take out a policy on myself that goes until I reach age 80. When I take it out, my premium is only $25 a month. Super cheap right? Well, each year, my life insurance gets a little more expensive and by the time I am age 60, the premium is astronomical. In the long run, it would have been cheaper to get a whole life policy, however, when I was 25, the premium fit my budget really well.
These are just the basics of term life insurance, and whole life insurance, but basically think of it like renting an apartment versus buying a home. When you have term life insurance it’s like renting: you have the protection for a length of time, but when you leave (like moving out of an apartment) you get nothing back. Whole life is like owning a home because if you leave or sell you get a savings back. Similar to owning a home, the value of whole life insurance increases--so you can think of the cash value or savings like home equity. The value of both go up over time.
How much life insurance do I need?
Now that you know the two main types of life insurance, let’s dissect just how much you need. The most important thing I used to tell my clients that there is not a one-size fits all amount of life insurance. Each person needs to figure out what is important to them to fund once they're dead. Some people have kids and a spouse that rely on their income, and a mortgage and debt and a funeral that needs to be paid. Someone else might be single without debt and just need to pay for a funeral. Here is how I broke down for people much they need for life insurance.
1. Pay off Debt
If you have any debt that won’t be forgiven with your death, make sure you cover that with your life insurance. Examples of this would be:
- Mortgage (if other people rely on this house for shelter, ie, your children and spouse)
- Vehicle debt (again if other people are relying on the vehicle, OR if someone else is cosigning for the vehicle with you)
- Credit card debt
- Personal loans
- Lines of credit
- Medical bills
- Private student loans (federal student loans are forgiven at death)
- Any debt that you are a cosigner on
2. Pay for a funeral
I always calculated this amount as $25,000. It gives the people who need to take care of your arrangements enough money to make sure the funeral, any hospital bills or any other random expenses are taken care of.
3. Children’s Education
If you have kids, you might want to consider covering their education. I usually factored 50,000-60,000 per child because we don’t know how much college education will cost in the future.
3. Ongoing income
This is the line item that most people don’t think about. They think once they have passed on, they’re gone and that’s it. However, if you have people relying on you and your income, your death is going to cause issues for their lifestyle. So how do you figure out how much ongoing income your dependents will need? It’s actually not that difficult. First, start with what your monthly take home income is. For me, my monthly take home income right now is $2,500. If I had a spouse or kids, they would rely on that income to live their lifestyle. Sure my significant other would be bringing in money as well, but only one income instead of two. Yes, there are instances where your income won’t be missed, but it's better to plan to replace it.
How long do you plan to replace your income? Well, that too depends on each person’s preference. Whenever I was planning for my clients, I always told them to replace income until your youngest child turns 20.
For example, a husband and wife are both 35, and have two kids who are eight and six.The wife brings home $4,000 a month and the husband brings home $3,500 a month. I will recommend 16 years of take home income to make sure the children and surviving spouse can live the same lifestyle.
This is how the calculation will look for both husband and wife.
If wife should die:
4,000 x 12 (months) x 16 years = 768,000
If husband should die:
3,500 x 12 (months) x 16 years = 672,000
Couple things to note:
- I didn’t include any inflation in my calculation. Why? Because each year that passes without death, your need for coverage (theoretically) drops. So yes, inflation would increase the amount needed to cover your lifestyle, however, each year you survive is one less that needs income. So you could take on a little more debt (not that I recommend nor disagree with more debt), or live a little higher lifestyle, and you would still have your ongoing income needs covered.
- I usually recommend a large chunk of this coverage be term insurance to keep the cost low. When you add the on-going income needs with your debt coverage, funeral coverage and future education costs, many people will need close to $1,000,000 of coverage. If you can afford that much whole life coverage, that is really freaking awesome! If you can’t afford that much whole life coverage, that’s okay. Take a small amount of whole life coverage so you can grow that savings and cash value, and use term insurance to cover the rest of your need.
While this is a really basic and rough guideline of the basics types of life insurance and how to calculate how much you need, I hope you still took value from it!