How Much Life Insurance Should You Purchase?

There is a constant balance to strike with every personal finance-related decision. With limited resources at our disposal, long-term planning and short-term cash flow are often at odds. This is certainly the case when it comes to life insurance. So, how much life insurance should you purchase?

The importance of caring for your beneficiaries after you are gone is a compelling reason to purchase life insurance. However, it does not mean that you should spend more than you can afford on premium payments in the here and now.

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How Does Life Insurance Work?

Those who wish to purchase life insurance will enter into a financial agreement with a company. In exchange for regular premium payments, the insurance provider will agree to provide a death benefit to the individual’s family after they die.

There are two basic types of life insurance: term life and whole life insurance. Term life insurance is fairly straightforward transaction. Individuals will purchase insurance for specific periods of time, generally 10-, 20-, and 30-year terms (hence the name of this type of policy). If you die during this timeframe, your beneficiaries will receive a death benefit. If you are living when your policy expires, no death benefit will be paid.

Whole life insurance, on the other hand, is a much more complex (and expensive) financial product. Not only does this policy never expire, but there is also a cash benefit that the policyholder can access during their lifetime. For this reason, those purchasing whole life insurance policies are generally focused on more than just the eventual death benefit that will be paid out to their beneficiaries.

This article will, therefore, focus on term life insurance.

Which Methods Can Be Used to Calculate Death Benefits for Term Life Insurance?

Term life insurance is mostly focused on those looking to help their families care take care of themselves if they pass away during their productive years. This can be for a primary breadwinner, as well as for an individual who solely works in the house.

Putting a monetary value on an individual can be a somewhat scary exercise, and there are a number of different methods that can be used to reach a monetary figure for those purchasing term life insurance.

(1) DIME Method: Those using the DIME approach will look at their current and future Debts, Income, Mortgage, and Education expenses. According to this formula, the death payment is determined by adding existing debts, current salary and an estimate for how long the policyholder’s dependents will need this income, remaining mortgage obligations, and expected future education costs for dependents.

(2) 10X Rule: The 10X rule is an exceptionally straightforward calculation. The policyholder will take their current income and multiply it by 10 to reach the desired death benefit.

Some individuals and companies encourage a sliding scale by taking into account future earnings. Under this approach, those in the earlier stages of their career would multiply their income by a greater factor (i.e., 30X for those under the age of 40).

(3) Obligations Minus Earnings Method: Similar to the DIME approach, the obligations minus earnings method will first compile the amount of money your family will need in the years to come. However, then, you will subtract any liquid assets from this figure to arrive at the amount of money your family will need.

(4) 10X Plus College: This approach is a slight twist on the 10X rule. Those using this approach would multiply their salary by 10X and then add $100,000 per child. This takes into account both future income and the educational expenses that your dependents can expect to incur.

How Should You Calculate Your Desired Death Benefit?

There are a number of ways that you can go about calculating your death benefit. Still, it is hard to put a numeric value on what it would take to make sure your family is protected after you are gone.

At the end of the day, the value of any prospective death benefit is related to the amount of your premium payments. Therefore, you should also consider how these regular benefits would impact your monthly budget and your other personal finance goals.

Coming up with your desired death benefit is therefore dependent on finding the right balance to cover your family into the future, without sacrificing your current finances. The various methods outlined in the section above can be good ways to reach this figure, or at least begin framing this calculation.

Because there are so many different variables at play, it is generally a good idea to discuss your individual circumstances with a financial professional who can help guide you through this process. They can help you weigh your premium payments with the death benefit that would provide you with the peace of mind that your family will be taken care of.

Conclusion: Taking Care of Your Family

Insurance agents have been known to quip that the beneficiaries of a life insurance policy should have enough to hold their heads up at the funeral but not too much that they are dancing on the grave of the recently deceased.

Though morbid by definition, there is some truth behind the joke. You want to leave your family in a good financial position but without sacrificing your current cash flow by purchasing more life insurance than you need.

Taking care of your family now and into the future is the crux of personal finances. Arriving at the right amount of life insurance should satisfy both of these criteria.

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