The following is a contribution from my blogging friend Gary at Gajizmo. If you’d like to contribute to Wise Dollar, please contact us.
Like any financial or estate planning decision, life insurance has many moving parts. It’s not just the type of policy you buy (term vs whole), but the amount of coverage, the length of time, the attached riders, the company you choose, etc. As you can see, it can get complicated and not all of us have the time to become life insurance agents to figure it all out.
This complexity may be the reason for some of these alarming statistics from research group LIMRA:
- 30% of U.S. households, or about 35 million, have no life insurance at all.
- 50% of U.S. households, or about 58 million, believe they have inadequate coverage.
- Of the consumers who believe they need life insurance, 86% haven’t bought a policy because they think it is too expensive.
Now granted, not everyone needs life insurance. If you’re a young adult with no financial dependents and no co-signors on debt (think student loans and parents), you likely don’t need life insurance. Remember, the purpose of life insurance is to insure the financial security of those who depend on you as a provider.
Below, we will discuss how to analyze and think through two important factors affecting your life insurance policy – the type of coverage and death benefit amount.
Term vs. Permanent Coverage – It’s Not A Hard Decision
There are two main types of life insurance – term versus permanent. But to make matters more confusing, within each type of category, there are dozens of different kinds of coverage. The most popular term policy is a traditional 20 year policy, whereas whole life insurance is the most common kind of permanent protection. Let’s make this simple – chances are you need term life insurance. Let me explain why.
A traditional term life insurance policy features:
- guaranteed fixed rates.
- a fixed death benefit.
- temporary coverage between 5 and 30 years.
- no investment component.
One of the reasons term is better than whole life is that whole life costs 5 to 10 times more than term. The average cost of term life insurance for a 35 year old, non-smoker is approximately $30/month or $360/year, maybe even cheaper from the best life insurance companies.
Now imagine that you are instead paying $1,800 to $3,600/year for the rest of your life for a whole life policy. And for what – lifetime coverage and a measly 4% guaranteed interest rate on a cash value, after fees and expenses? This may be why the Society of Actuaries (SOA.org) reported that 39% of whole life policies are canceled within 10 years of issuance.
You may be enticed by the “guaranteed interest” part of this equation due to the volatility in the stock market lately, but don’t be fooled. After adjusting for inflation (which your 4% whole policy doesn’t account for), the stock market has returned an average 8.54% in the last 100 years.
This is the main reason any true and honest CFP® or financial advisor looking out for your best interests will easily recommend a term life insurance policy and passive mutual fund investments.
Calculating How Much Life Insurance To Buy
The other big factor affecting your life insurance policy and rates is the amount of coverage you purchase, also known as the death benefit or face value. The amount you purchase determines the payout your family will receive in the unfortunate event of your death.
Calculating your need for life insurance protection can be difficult and costly if you don’t know what factors to consider. Over-insuring yourself or your spouse can result in straining your existing budget and shortchanging your retirement planning, while under-insuring can leave your family in dire straits.
While LifeHappens.org has a great life insurance calculator, the primary contributors to the question “how much life insurance should I have?” are the following:
- Final Expenses – burial and funeral expenses average between $10,000 and $15,000, depending on the state you live in.
- Mortgage – your outstanding mortgage is probably your largest financial burden, but is also arguably the most necessary. You’ll probably want to pay that off.
- Other Debts – this includes your car, student, business, and personal loans.
- Future Education Costs – you may want to provide assistance for your kids when they go to college.
- Living Expenses – consider the daily living expenses your family will incur, including basic necessities, food, utility, credit card bills, etc.
The above are essentially your family’s cost of living. Not cheap, huh? Sometimes, I think about every little thing we pay for in America, from the cell phone bill to car insurance to basic vacations, and it’s no wonder middle-class families are struggling to get ahead. But I digress…
You will compare this need for income replacement against your existing assets, such as your savings/checking accounts, IRA, 401K, pension, and other investments as well as your spouse’s annual income, if applicable. The difference will be your life insurance need.
In the end, the amount of life insurance you “should” buy is contingent on your lifestyle and how much financial security you want to provide for your family after you pass.
Treat life insurance like you would any other product or service – compare term life insurance quotes to find the best company, coverage options, benefits, and premiums.
However, when buying life insurance, please keep in mind that the policy or company with the lowest premiums is not always the best choice for you and your family. As we mentioned, each life policy has its own pros and cons and whether a specific type caters to your needs depends on your life situation and circumstances.
What do you consider when you’re looking for life insurance? If you don’t have life insurance coverage, how do you plan for your heirs to take care of your final needs? Do you prefer term or whole life?