How Much Life Insurance Do You Need?

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The following is provided for informational purposes only and is not intended as legal advice.

As far as budget items go, life insurance is...not one of the big ones. NerdWallet estimates the average cost to be around $26 a month (roughly the cost of a burger and small fries from Five Guys). But that's an average and the actual cost can vary pretty wildly depending on the kind of coverage, the amount of coverage, and your health (among other factors).

But when money is tight and every dollar counts, it's important to make sure you're paying for the correct amount of life insurance. So let's take a look at life insurance: what it covers, what it costs, and how much you actually need.

What is life insurance used for?

First things first: what's the point of life insurance?

Life insurance exists to provide financial protection to your beneficiaries in the event of your death. You pay into the life insurance policy while alive (hopefully for many, many years) and when you pass the policy is paid out as stipulated in your agreement. The most common ways that life insurance is used includes:

Death benefit

The death benefit is a lump-sum payment to your designated beneficiaries upon your death. This amount is generally tax-free for the beneficiaries.

This is the primary purpose of life insurance and there may or may not be additional directions for this money.

Repayment of debts

The death benefit can be used to cover various financial obligations, such as outstanding debts, mortgages, loans, funeral expenses, and medical bills. 

Is the deceased still responsible for any debts they left behind? While the deceased debtor isn't, their estate is, which is why life insurance benefits may end up being used to repay the deceased's remaining bills. 

Income replacement

Life insurance helps replace the income you would have provided to your dependents. This ensures that your family can maintain their standard of living and cover day-to-day expenses even after your passing.

Education expenses

If you have dependents, life insurance can be used to fund their education expenses, including tuition and other related costs.

Business continuity

In the case of business owners, life insurance can be structured to provide funds for business continuity, including the buyout of a deceased partner's share or to cover debts related to the business.

Charitable contributions

Some individuals use life insurance as a means to make charitable contributions by naming a charity as the beneficiary.

How much life insurance coverage do you need?

The more life insurance coverage you want, the more you're going to pay in monthly premiums. So while it may be tempting to get the biggest policy possible to leave your family with plenty of money, that may not be financially feasible.

Instead, you may want to take a more calculated approach at determining the right amount of coverage. Here's what you should consider.

What do you need to pay for?

What are some of the big expenses you expect to cover with your life insurance payout?

  • Funeral expenses. Many people consider the costs of their own funeral when determining the coverage amount. That's because funerals, cremations, and burials are all quite costly and most people don't want to leave those costs to their family.
  • Outstanding debts. Because your estate is still responsible for your debts after you die, you may want to make sure your policy is large enough to cover things like your mortgage, car loan, student loans, and credit card balances.
  • Education expenses. If you have dependents, you may want to make sure there's enough in your policy to help cover the cost of a secondary education, including tuition and living expenses.

How much will your family need to live comfortable without you?

It's sad to think about, but if your life insurance policy is paying out that means you're gone and your remaining family will need to manage without you. That's a tricky needle to thread, but there are some general factors to consider.

  • Current income. How much income will your dependents need to maintain their current standard of living? A common rule of thumb is to aim for coverage that's 5 to 10 times your annual salary.
  • Family needs. Are there any special costs for one or more of your dependents that you need to cover? Consider your family's daily living expenses, healthcare, and other ongoing costs. 
  • Goals. Do you want to leave a charitable contribution? Do you want to help your family buy a house or reach some other goal? Consider potential expenses above and beyond your family's day-to-day expenses.
  • Assets and savings. How much do you have saved and available to use? Subtract your existing savings, investments, and other assets from your financial obligations to determine the gap that life insurance needs to cover.
  • Inflation. Unfortunately, things keep getting more expensive, so keep that in mind and adjust accordingly.

Periodically reassess your life insurance needs, especially during major life events such as marriage, the birth of a child, or changes in your financial situation. Remember that the right amount of coverage is highly individual and can vary based on personal circumstances.

What policy type should you pick?

Beyond knowing how much coverage you'll need, you also need to figure out what kind of policy is best for you. The two main types of life insurance are:

Term life insurance

Term life insurance provides coverage for a specific term (e.g., 10, 20, or 30 years). If the insured dies during the term, the death benefit is paid to the beneficiaries. If the term expires and the insured is still alive, there is no payout.

At the end of the term you'll have the option to renew, but not necessarily at the same rate. This means that term life insurance is usually cheaper when you're younger. As each term expires and you get older (and riskier from an insurance perspective) the insurance becomes more expensive. 

Whole life insurance (permanent life or universal life)

Whole life insurance provides coverage for the entire lifetime of the insured. These policies typically include a cash value component that grows over time, and they may offer additional features such as the ability to borrow against the cash value.

Whole life insurance is usually more expensive than term life insurance, but doesn't become more expensive as you get older.

Comparing the two, whole life is the better long-term investment, but term life may be the more affordable option, especially when you're young and just starting to earn an income. 

What determines the cost of life insurance? 

There are quite a few life insurance companies out there and their criteria will vary, but some of the most common factors in setting your life insurance premiums include:

  • Age. This isn't ageism so much as it's just statistical probability: younger individuals are statistically less likely to die during the policy term. Therefore, the younger you are when taking out the policy, the lower the cost.
  • Health. Your health plays a significant role in determining life insurance premiums. Insurers typically assess your overall health, medical history, lifestyle factors (such as smoking), and may require a medical examination. The healthier you are, the lower your premiums.
  • Coverage amount. The amount of coverage you choose (the death benefit) directly affects the cost. Higher coverage amounts result in higher premiums.
  • Type of policy. As noted, term life insurance is usually cheaper than whole life insurance (at least for younger individuals). 
  • Gender. Women, on average, tend to live longer than men, and this can impact life insurance premiums.
  • Occupation and hobbies. Not all jobs are the same when it comes to risk. Firefighter is an inherently more dangerous profession than, say, marketing manager at a nonprofit. Risky occupations or hobbies (like free climbing) may result in higher premiums due to increased risk.
  • Location. Have you ever moved and then discovered that your car insurance is suddenly much more expensive? The same goes for life insurance. Your geographic location can influence life insurance rates due to regional variations in mortality rates and healthcare costs.

As with anything costly and complicated, be sure to work with a qualified professional to assess your options and find the right policy for your needs.

If you're worried about leaving debts behind, now's the time to work with a professional to work through your options. MMI offers free financial counseling 24/7, online and over the phone. Let our experts help you find the right solution for your specific challenges.

Tagged in Advice for families, Insurance

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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