To figure out the correct amount of life insurance that you need to carry, there are a number of factors to take into account.  In addition, because different types of life insurance serve different purposes, and have different costs, drawbacks, and benefits, it is important to understand how you needs are likely to change over time.  Understanding how your needs may change over time can help you save a lot of money in the long run, and help you structure your life insurance coverage most efficiently.

While life insurance calculators may give you a good approximation of the amount of coverage that you need, they can not take all factors into account.  At Life Ant, we provide a life insurance calculator for your convenience as well.  This does not take every possible factor regarding your personal situation into account, and before using any calculator you should understand that it is a simplified estimate of what your true need may be.  This guide will help you to calculate the correct amount of life insurance that you should carry, and it will help you to understand what types of coverage you need.

First Method-Pay Off Debts

The minimum amount of life insurance that you should hold is enough to pay off all debts that you will pass on to others.  Usually a spouse is the remaining family member that will inherit debt, but in some instances it may be the surviving children, or business partners.

The most common debts that need to be repaid are mortgages, credit cards, student loans, home equity lines, and business loans.  It is important to account for all debts which could be left outstanding if a death occurs though.  Other debts which may be left outstanding include auto loans, financing on furniture, financing on electronics, short term loans, taxes, and even money borrowed from friends and family.

Future debts can also be taken into account such as children’s future educational needs.  If a large future need has to be funded, please keep this in mind as a fixed debt when you calculate your total.

The total of all debts is the absolute minimum amount of life insurance coverage that a person should maintain on their life.  This will not necessarily provide the necessary protection, however, for the beneficiaries to maintain their standard of living, or even a basic standard of living in the event of a death.

The idea is that if the debts are paid off, the remaining family members will be able to earn income at a rate at least sufficient to provide a minimally acceptable standard of living.  Use this method if you are looking to provide a level of protection which very affordable.  Term life insurance is usually sufficient to pay off debts, assuming the length of term is at least sufficient to cover the period that debt payments will last.  If you expect to die with debt, whole life insurance might be needed.

Second Method- Replace Lost Income

A second method of calculating the total amount of life insurance coverage that you should carry is the amount that it would take to replace the amount of income that you are likely to make for the rest of your working lifetime.  There are a couple ways of doing this.

The first is to take the current amount of money that you make per year in salary.  Take the age that you are likely to retire, and subtract your current age from this number.  The result is equal to the number of years of earning that you have left before retirement.  Take your current salary and multiply it by the number of years remaining until retirement.  This will give you your total future earnings potential.  A life insurance policy ideally will replace all future earnings of the insured person.

A more complex way of calculating lost earnings is to consider likely raises, and consider the average rate of salary inflation.  Many advisers recommend using a figure of about 3%-5% as an expectation for future salary inflation.   You could take the total sum of each year’s expected pay, and this should approximate more closely the total amount of life insurance that should be carried on a life.

This method sometimes will give a higher than necessary amount of life insurance coverage because it does not take into account the actual needs and current assets of beneficiaries and sometimes may replace income which is superfluous to what is needed for the beneficiaries to live comfortably.

Best Method- Needs Based Approach

This can only really be done by a financial advisor unless you are very good at math, and have a lot of time, or a professional program designed to calculate the outcome.  The needs based approach to calculating life insurance coverage involves calculating what is really needed for the beneficiaries to survive comfortably, and to calculate the shortfall from that goal the beneficiaries would be left with if the insured person dies.  This calculation takes into account current assets and the ability of beneficiaries to earn income in the future.  This is not a complicated concept to understand, but it can involve many factors.

From an academic perspective, the goal is to calculate a net present value of an amount which would fully fund the shortfall for all future needs. A discount rate equal to a conservative estimation of the expected rate of return net of inflation of all future liquid capital can be applied to find a “net present value” or in other words the amount of life insurance coverage that you need.

The first and easiest step is to assume that all outstanding debts should be paid off immediately.  This is a dollar for dollar need.  Take into account the fact that current liquid assets can be used to reduce debts as well.

The next step is to calculate the amount of money the beneficiaries (usually a family) needs to survive comfortably.  Take the current amount of spending above all current outstanding debt service (i.e. mortgage payments) that the family needs to maintain their current lifestyle.  Inflate this lifestyle cost number at the expected rate of inflation, and take the sum of every year for the rest of the beneficiaries expected life.  Please note that children likely do not need to be supported beyond age 18 or 22, so any spending needs for the children should end at this age.  Take into account any lifestyle changes likely to occur as well, such as an increase in spending during retirement for vacation purposes. When calculating the needs for a spouse of the insured, consider the spouses  need for financial capital to last for the rest of their life.  Take into account that many middle aged people today will live beyond 90 years of age as the average length of life continues to increase in developed countries.

The goal of the above calculation is to find the amount of money that would need to be put into an investment account, earning some conservative estimated rate of return, which will fund all future spending needs.  This is the net present value of the amount of money the surviving members of the family will need for the rest of their life to maintain their current lifestyle.

Add in any needs for college education funding.  It is recommended by financial planners that you build in an inflation in the cost at a greater rate than current inflation expectations for the economy as a whole, as the increase in the price of higher education has historically outpaced general inflation in the economy.  After figuring out the total amount of money that will need to be spent on education(s) (depending upon the amount of children likely to attend college) in the future, figure out the amount of money that will need to be put into a conservative investment account today to fully fund this need.

Simply put, these are the steps to calculate your coverage need:

  1. Figure out the total amount to pay off all debts that is needed beyond current liquid assets.
  2. Figure out the total amount of money it will take to fund all future spending needs beyond and current assets available to satisfy this need.
  3. Calculate the amount of money that you need, invested at a conservative rate, which will satisfy the above points.
  4. Add any additional money that you would like to leave future generations as a legacy or to pay inheritance taxes (if applicable).

This will give you an exact calculation of the amount of life insurance coverage that you will need to hold in order to completely provide for your beneficiaries.  Using this method both reduces the amount of wasted coverage and increases the odds that you will be leaving enough for your beneficiaries so they never want financially if you were to pass away.

How To Structure Coverage- Mixing Term and Whole Life

Term life insurance and whole life insurance have very different purposes.  Sometimes a person may need term coverage only, sometimes a person may only really need whole life insurance, and sometimes a mix of both types of coverage are appropriate.  Some things to keep in mind when designing your mix of coverage.

Term Has Multiple Coverage Lengths Available

Term life insurance is an incredibly flexible product.  You can purchase level term life insurance for as little as 5 years, and as many as 35 years, generally with 5 year increments available in between.  The longer the length of the term coverage, the higher the level premium will be.  This is because the longer the life insurance company covers you, the higher the odds are for them that you will pass away while you hold the coverage.  If you are likely to be in a very different financial situation in 5 years than you are today, it may be appropriate to purchase a lower length term policy.  If you anticipate needing coverage until retirement, but you believe that you will have saved plenty of assets by the time you retire to negate the need for continued life insurance coverage, you may want to purchase a policy with a term length which corresponds with your likely retirement age.

Term Can Be Convertible

Also important to keep in mind is the fact that term life insurance is usually convertible into whole life insurance for some period of time after it is purchased.  If you are unsure if you will need whole life insurance in the future, but want to keep your options open to purchase a whole life policy, don’t forget that most term life insurance policies allow for a future conversion.  Always check with your life insurance provider on their exact rules regarding term conversions, because every company does vary slightly regarding what point the conversion option is available.

Whole Life is the Only Product for Estate Planning Purposes

If you have an estate planning need to fill, such as the need to pay estate taxes, or you would like to leave a legacy to the next generation, whole life insurance is the only appropriate product.  This is because only whole life insurance is guaranteed to be in force your entire life with level premium payments.

A Mix of Different Length Term Policies, or Whole Life and Term May be Best

You may know that your house will be paid off in 5 years, and you can drop a significant amount of insurance coverage at that point, but you want to lock in a policy now while you are healthy that will also last for a long time, you may want to get one short term term policy to cover the mortgage payment, and one longer term policy that will last until retirement or beyond to provide for living expenses (don’t forget that reducing face “mortgage life insurance” policies also can be purchased from most insurers).  You may need extra coverage while you are young, but also have an estate planning need, and a mix of whole life and term life may be appropriate.  An integrated approach to life insurance can sometimes be the most cost efficient solution.

Calculating Your Need

If you want a simple solution to this question, think replacing lost income.  Remember, the minimum amount that you should carry is enough to pay off all debts.  Life Ant also provides a Life Insurance Calculator for your  convenience.  If you still have questions, we advice that you talk to a financial advisor.  Remember, you can always get quotes for different amounts of insurance from Life Ant, which may help you decide what is affordable for you.