How much term life insurance do you need?
"How much term life insurance do I need?" It's a question you're bound to ask yourself when facing a big life change (marriage, children) or, for that matter, your insurance agent.
The short answer? The amount you need is unique to you--your life stage, your income, your marital status and your dependents. In other words, there is no short answer, so consider these guidelines when deciding on the right amount.
What is term life insurance?
First off, it's important to understand what term life insurance is. You purchase term life insurance for a certain period of time--say, a $500,000 policy with a 20-year term. As long as you pay premiums during those 20 years, your beneficiaries are guaranteed to receive $500,000 if you die during that time.
Term life insurance is relatively inexpensive for young, healthy individuals. Because of that, it's a sensible companion to an emergency fund when figuring out how to ensure a young family's financial stability.
Who depends on your income?
It's not the most pleasant daydream you'll have, but imagine who and what you would leave behind if you were to die tomorrow. Is there a wife or husband in the picture? Children? Parents who are living on a fixed income? Do you have a mortgage or rent to be paid by survivors, or other outstanding loans for items your family needs, like a car?
For those with spouses and children, term life insurance can replace income lost by the death of a breadwinner. A check from the insurance company can pay off a mortgage, fund a child's college education or simply keep the utilities on for years into the future.
Term life also benefits singles and stay-at-home parents
If your life seems simple by comparison, consider this: Average "final expenses"--including medical bills, funeral costs and final estate settlement costs--are roughly $15,000 or 4 percent of the estate, whichever is more, according to the Life and Health Insurance Foundation for Education. Someone will be responsible for paying those bills, whether it's a spouse or another loved one.
Stay-at-home parents may dismiss term life coverage as an unnecessary expense; they have no income to replace. It's not that simple, however. A family facing the loss of a stay-at-home parent needs the help that parent provided--daycare or after-school care, cooking, cleaning, chauffeuring. Money won't replace a lost parent, but it can pay for services that will get the survivors back on their feet while the remaining parent goes back to work.
Rules of thumb and online calculators
So, how much term life insurance do you really need? Start with one of the general guidelines to get an idea. A commonly quoted estimate is five to 10 times your current annual salary. So, if you make $40,000 a year, you'd be looking at a $200,000 to $400,000 policy. For greater payoff, MSN Money notes two other guidelines: 17 times your annual salary or a sliding scale based on your age.
While these guidelines are a good starting place, financial advisers are quick to dismiss rules of thumb as too narrow because they don't take into account your specific needs. Online calculators allow you to customize your estimate by asking not only for your salary, but debt obligations, number and ages of children, and more.
Here are a couple:
Online calculators have drawbacks, however. They often don't offer options for nontraditional families, so it can be confusing to determine what data to include for your particular situation. Calculators can be skimpy with explanations of the terms they use or how the final figures are reached.
The do-it-yourself method
Alternatively, if you are comfortable with a pocket calculator, you can run some numbers yourself. A Kiplinger.com article describes a method by financial planner Tim Maurer, co-author of the book The Financial Crossroads.
Maurer notes that many online calculators and rules of thumb can easily be off base:
"You can find people who are extremely minimalist with insurance recommendations. But I see an overabundance of people who end up justifying more insurance than I think is reasonable."
Maurer defines four critical categories--your final expenses, mortgages and other debts, education expenses and income replacement--and describes a formula to estimate your family's needs if you die. He notes that these calculations are "an art as well as a science." By doing these calculations yourself, you may end up with an amount that better meets the needs of your own family and loved ones--not just a ballpark average.
Term life: the Goldilocks approach
While it may be tempting to load up on term life coverage as a talisman against a worst-case scenario, there are drawbacks to overinsurance. While term life policies are relatively inexpensive, the extra premiums you pay when you overinsure could be better spent on other goals to achieve financial security: paying off bills or your mortgage and investing for your future.
On his Get Rich Slowly blog, J.D. Roth offers this food for thought,
"It's easy to just get a large amount of insurance (just to be safe), but the reality is that if you are over-insured, then you're paying a lot of extra money over 20 years. Plus, you don't want to give your beneficiaries any extra incentive to bump you off!"
A cheeky observation, certainly, but a valid point: Coverage that fits is the best option for everyone.
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