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How Does A Person Determine How Much Life Insurance They Need?

In a recent Q and A column I made reference to a rule of thumb, purchase 8 to 10 times your annual income in term life insurance.  This is a very general rule.  Today, I want to help you to zero in on a much more accurate way to go about this.

First, my philosophy on life insurance is that it should be a replacement for lost income if a wage earner dies.  With that being the premise, what we first have to do is to decide how much income we are trying to replace.  Let’s say for this example, that we have a wage earner with $50,000 of annual income.  To create $50,000 of income from an investment account, you would likely need $625,000 if the account were to average an annual return of 8%.  Depending on how much risk you are willing to take and what investments would be employed in your plan, you would have to work through these numbers to come up with your personal insurance need amount.

Another, more involved method, would take into consideration paying off debts and then determining what amount of income would be required if the family were debt free.  For example, if there is a car loan of $25,000 and a mortgage of $200,000 and credit card debt totaling $10,000, we could pay off all of this with $235,000.  In this scenario, if these debts were costing $3,000 in monthly payments we could subtract that from our monthly income needs.  So, we might only need $2,000 in monthly income if all of the debts were paid off.  The amount we need is $235,000 (to pay off all debts) and then enough to create $2,000 in monthly income ($300,000 using our earnings rate of 8% as we did above).

As you can see this is really not that complicated when you start working through the numbers.  Probably the most difficult part for most people is converting the amount of income they will need monthly into a required lump sum amount.  This is a very easy calculation.  Annual income divided by earnings rate = lump sum required.  For example, $24,000 (annual income needed) divided by .08 (8 percent earnings rates) = $300,000 lump sum required.

One other factor, I have addressed in my books is planning for the loss of of a non-working spouse.  If you have younger children, you should plan for the need to hire a housekeeper/babysitter to assist you in running the home.  Again, decide on amount you would need.  For example, $20,000 per year and do the calculation and the total coverage required would be $250,000.

Overall, the biggest mistake people make is not having enough life insurance.  Over the years in doing financial consultations I have rarely run across a person that prior to their consultation with me had enough life insurance.  Remember, that the key to being able to make life insurance affordable is to stick with term life insurance.  I recommend utilizing level term, which can lock in your annual premiums for as long as 20 years at very affordable rates.

If you have a financial question you would like answered in a future column, send it to

Agree or disagree with my advice, click on comments below.  

Helping you make the most of God’s money!

James L. Paris
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