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How Much Life Insurance Do I Need?

Friend of the blog Matt sent in a great question this week:

Hi Jesse – do you have any recommendations when it comes to life insurance? I know Term is the way to go, but that’s about all I got…

I scanned your blog posts and didn’t see anything too specific with it but if you have any guidelines for pricing or coverage recommendations, please let me know!

Matt

Matt’s Right. We Want Term!

Matt’s right. Term life insurance is the best option in 99.99% of cases.

Other types of life insurance (Whole, Variable, Universal, etc.) are bloated products that are “pushed” and “sold” far more often than they’re genuinely sought after. These products try to combine Investing with insurance and end up being overpriced versions of each.

How Much Life Insurance Do I Need? &Raquo; Image 12 1024X767 1
Some things aren’t worth combining!

The smarter option is to buy insurance that only acts as insurance and then use your remaining Money to invest in pure investments. Term life insurance is just that life insurance product. All it does is provide money to your beneficiaries if you die. If you don’t die, it doesn’t pay. It’s simple.

But Do We Need Life Insurance?

How do we determine if someone needs life insurance?

I use the same framework I would use for any insurance question (home, boat, pet llama insurance, etc.).

Are you exposed to a financial risk that you could not comfortably recover from using your current asset base?

Let’s say your house burns down. Does that present a financial risk you could recover from using your current assets (cash, investments, etc)? If you answer no, then you need home insurance. (If you have a mortgage, your lender likely mandates you have insurance so they’re covered should the house burn down).

Flare Of Fire On Wood With Black Smokes

If your wedding ring got stolen, does it present a financial risk you could recover from? Personally, I wear a ~$200 tungsten carbide wedding ring. If my finger got stuck in a tragic 3-ring binder accident while compiling someone’s financial plan, I could replace that $200 ring without issue. I do not need ring insurance. Granted, the cosmetic costs of finger reconstruction might make me wish I had better health insurance…

Back to the point: that’s the framework to use! Does the downside risk present an insurmountable financial burden to you (or your beneficiaries?)

The answer for many younger readers with dependents (spouses, children) is a screaming YES. As in, “If I died and the family lost my income, it would be very financially uncomfortable for many years!”

But how much coverage do you need?

My Preferred Methods: Income Replacement and “DIME”

The two methods I prefer (and suggested to reader Matt) are the Income Replacement method and the DIME method.

Income replacement suggests you replace your income for a certain number of years, typically until your children reach a particular age or until your spouse reaches Retirement age.

In my personal case, I wanted to replace my income until my youngest child (who is still technically hypothetical) is out of the house. I chose a 30-year term policy equivalent to ~20 years of my income (with a small discount rate for future years). No matter when I get hit by that proverbial bus, 20 years of income should cover my youngest child until they’re out of the house.

Little Girl Playing With Wooden Blocks At Home

The DIME method adds up any outstanding debts, add in your income for a certain number of years, then adds your remaining mortgage, and finally adds on future expected Education costs. Debts, income, mortgage, education.

The DIME method double-counts a few things. For example, I’m using my income to pay my debts and mortgage. I shouldn’t need to double-count them. Nevertheless, I like the idea of itemizing the biggest future expenses (college costs, mortgage payoff, etc.) and ensuring your life insurance policy can cover them.

The Best of the Rest

Other strategies I’ve seen for sizing life insurance policies include:

The Human Life Value (HLV) method. It asks an individual to consider their annual income for each year until their retirement, add in other benefits and bonuses, subtract the income used for their personal consumption, and then discount future income to today’s value.

Done correctly, this method should provide the beneficiaries with a lump sum of the resources you would have expected to provide to them over the remainder of your working life. It’s just a bit too complicated and mathematical for most people to get right.

Clear Glass With Red Sand Grainer

The Budget-Based method simply multiplies your household’s monthly expenses by the number of months you expect those expenses to be maintained. It’s similar to Income Replacement, but looks at expenses rather than income.

Lastly, the “Rule of Thumb” (which I think is a poor name!) suggests you multiply your income by 10. Very much “one size fits all,” which is why I don’t like it.

Granted, one detail to note is that most life insurance sizing strategies are intentionally conservative, leading to policy sizes that are large enough during the highest-risk years but end up being too large as time goes on.

For example: a young family might need a $2M, 25-year policy on each parents. But by the time the kids are in college, that $4M of total coverage is surely too much.

Thanks for the question, Matt!

And to all of you: term life insurance is a smart financial planning move. But I hope none of you ever need to collect!

Thank you for reading! If you enjoyed this article, join 8500+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week. You can read past newsletters before signing up.

-Jesse

Want to learn more about The Best Interest’s back story? Read here.

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Jesse Cramer Writer & Financial Planner

Jesse Cramer is the writer of The Best Interest blog, the voice behind The Best Interest Podcast, and works full-time as a fiduciary financial planner for Cobblestone Capital Advisors in Rochester, NY.

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