Purchasing a life insurance policy is a wise financial decision that ensures protection and security for you and your loved ones. The amount of life insurance that you require will vary based on current and future circumstances, but there are some important considerations that can help you ensure proper coverage.
You may know of a few rules of thumb when it comes to determining the proper amount of life insurance. If not, than let us review the three rules of thumb about life insurance coverage – and whether or not they are true.
Rule-of-thumb #1: Multiply your income by 10-15x
Perhaps the most common rule of thumb that can be found throughout countless articles on life insurance. After all, this has been THE common reference point for decades. On the surface, this would seem to be a good estimate – and in some cases, this is pretty accurate, but for the vast majority of people, this might be too simple.
The world has changed and continues to change in so many ways since this first rule of thumb was introduced. Most households now rely on income from both spouses to make ends meet as debt levels climb and the cost of housing skyrockets at a level far above the increase in incomes. The reality for many households is that they require much more than 10-15 years of income to sustain their lifestyle and reach their retirement goals. Mortgages now carry a longer amortization terms (the amount of time you have your mortgage before your home is paid off) of 25 or even 30 years. In many cases, most households require a sustained level of income throughout that period – much longer than the 10-15 years of income replacement.
Calculating the need for life insurance based solely on income can also create scenarios where you may be left underinsured. For example, if there is a couple where one spouse earns most of the income, their partner’s life insurance need would be underestimated due to a lower income. By providing care to their children, it allows the other spouse to work full-time and also reduces the cost they would have to pay out of pocket for childcare. If something happened to the caregiving spouse, childcare costs would increase dramatically and there is the potential for income of the surviving spouse to drop if they are required to take on more of the responsibilities. If the stay-at-home parent is not earning an income, or is earning a part-time income, the 10-15 times income rule will leave the family underinsured in an already difficult situation.
Another scenario where this calculation may lead you astray is if we consider two separate individuals earning an equal wage – say $60,000 annually. Each of the two individuals have the same income, and therefore would have the same level of life insurance need according to the 10-15 times income rule. However, there are many other factors at play. In this scenario, let us say that one of these people has an outstanding mortgage of $300,000, two children that they would like to provide education support for, and an elderly parent that requires their income for support on top of their spouse and children. The second person is single with no dependents and was able to pay off all their debts including the mortgage on their house. You can see that each individual scenario can be very different when it comes to life insurance. Sure, the second person might require 10-15 times salary if they plan on getting married or having children in the future, but their need may also be lower. What we assume is that the first person, with a mortgage, a spouse and two children that rely on their income, as well as a dependent parent, most likely requires a much larger amount of insurance coverage than the second individual.
With that being said, the 10-15 times income rule is not a bad rule. There is just more to understanding your life insurance need than this simple calculation.
Rule-of-thumb #2: See rule #1 (10-15x annual income) plus $100,000 per child for post-secondary education
You also have to acknowledge the fact that children have a significant impact on life insurance needs of an individual. Many of the thoughts shared about the first rule of thumb remain true, but there is a clear increase in the amount of coverage required for any individual with children.
In the first scenario listed above, we looked at a couple with one primary income earner and one in the primary care role. Using this new calculation, their need for insurance would increase by $100,000 per child, which would be a significant improvement in coverage. Although this additional value is based on the cost of post-secondary education, these funds could be used to provide childcare for the children in the short term in case there was a loss of a parent.
In the second scenario, we compared a family with two parents, two children, a mortgage, and a dependent parent with another individual that earns an equal income, but has no debts, spouse or dependents. It was clear that there was a difference in life insurance need between these two scenarios, but our first rule of thumb would not have identified this. In this case, there would be an increase to both spouses’ life insurance coverages of $200,000 for post-secondary education, which would be a welcome increase in coverage.
The cost to raise a child and the amount of life insurance required to protect that need can also vary. Factoring in an additional $100,000 per child is certainly helpful, but some parents may expect a higher need if they plan to provide funds above and beyond post-secondary tuition costs. This may include additional years of education, a deposit on their first house, or help to pay for their wedding.
Although this method is still far from perfect – it is an improvement on the first rule of thumb as it identifies the additional need for insurance for any parent of a child. Again, there are situations where your life insurance needs will fall within this calculation window – and it certainly does happen. But it’s up to the individual to plan ahead for your unique needs.
Rule-of-thumb #3: The LIFE formula
This formula is the basis for our life insurance coverage calculator, which is designed to take a more detailed look at your financial situation than the first two calculations discussed. LIFE is a helpful acronym to remember this analysis as it stands for Loans (all debts & mortgages), Income, Final Expenses, Education – four of the key areas of consideration when assessing your life insurance need.
- Loans, debts & mortgages: Add up your outstanding debts, including your mortgage. If you currently don’t have a mortgage, but are planning on getting one, an estimate can also be included here.
- Income: Replacing your after-tax income to provide financial support to your family is a key component. Your monthly income need can be reduced by any monthly payments you normally make towards any debt that would be paid off by your life insurance (outlined above).
- Final Expenses: Funeral expenses can be in excess of $13,000 for a traditional funeral service. You also have to factor in things like probate and legal and accounting fees to settle an estate. These are all considerations for final expenses that may be incurred.
- Education: Estimated cost of sending your children to post-secondary education. Remember, the cost of post-secondary education has increased significantly in Canada year over year, and continues to rise.
By adding up these obligations, you will get a much more personalized view of your life insurance needs. Once identifying your life insurance needs, it is important to factor in any savings or insurance you already have in place to provide financial support for your loved ones. In addition, it is also important to consider the value of a primary caregiver and the additional child care costs that could be incurred if they pass away. Although there is no perfect formula, this calculation will certainly give you a really good idea of the coverage you may require.
Ensuring you have proper life insurance protection in place will provide you and your loved ones with peace of mind knowing that they are financially secure. Our team of licensed professionals at Hometown Life Insurance are here to assist you by providing tailored recommendations for your life insurance needs. By speaking with an expert, you can take the guesswork out of your life insurance calculations and provide financial security to your loved ones, no matter what happens.
