In our first series on life insurance, we discussed the various types of policies offered, along with when each type of policy would make sense in your life. Now that you have an idea of which type of policy meets your needs, you’re probably wondering how much of it you need! This second series on life insurance will be a helpful resource on where to start when estimating your life insurance need.
Human Life Value Approach
One simple and easy way to estimate how much life insurance you need is by using the Human Life Value Approach. With this approach, you multiply your annual salary by a multiple, most commonly 6 through 10. The multiple you choose should depend on your age. For example, if you are younger, you will want a multiple closer to 10 because you will need to replace your income for a longer period of time should you pass away unexpectedly. On the other hand, if you are an older individual, you will want a multiple lower than 10 because the number of years you will need to replace your income for your dependents will most likely be smaller.
While this method is a good starting point to determining how much life insurance you need, it isn’t completely accurate because it doesn’t consider factors such as inflation, the changing economy, or major expenses.
A more thorough way to determining your life insurance needs is by using the DIME formula. The DIME formula takes into account various factors that the Human Life Value Approach does not. The DIME method looks at your debts and final expenses, income, mortgage, and children’s education.
Debts and Final Expenses
The first step of the DIME formula is to add up all of your current debt such as your credit card debt, student loans, and car loans. When you die, your debt doesn’t disappear; it passes right to your heirs! Accounting for your debt and including it in your life insurance death benefit will allow for your dependents to have the funds to pay it off, rather than being stuck with it. You will also want to include the expenses for your funeral, which can be pretty costly; funeral costs can fall between $7,000 and $10,000. This lifts a huge burden off your family’s shoulders when planning your funeral arrangements.
The next step in the DIME formula is to you multiply your annual income by the number of years you think that your dependents would need your financial support. For example, if you have dependent children, you typically need to provide financial support until the youngest child turns 18 years old.
Another liability that you should account for is your mortgage. If you are still paying a mortgage, your life insurance benefit should include the funds needed to pay off the remaining balance on the policy.
If you have children and want to pay for their college education, you should budget for that in your life insurance policy. The typical rule-of-thumb is to allocate $100,000 per child for a four-year university at a state school.
After adding up all of these factors, the DIME Method provides you with an estimated life insurance need. Again, this method still does not account for inflation or the changing economy, but it does gives you a great starting point for determining how much life insurance you need.
Everyone’s life insurance needs are different, so feel free to reach out to us if you have any questions regarding life insurance in your financial plan. This information is not intended to be a substitute for specific individualized advice, and we suggest you discuss your specific situation with a qualified financial advisor.