Should You Invest in Life Insurance?

Posted by Bruce Mc on Sep 9, 2010 in Information, Opinions | 0 comments

The purpose of life insurance is to provide a source of income, in case of your death, for your children, dependents, or other beneficiaries.

Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance.

Life insurance protects your family in the event of death. Most people do not have the right amount of insurance. It is important to determine the amount that suits your needs.

There are two basic types: term and permanent. Term insurance is simply insurance that covers a specified period. If you die within this time frame, your beneficiary receives the insurance benefit. Term policy premiums usually increase with age.

Permanent insurance, such as universal life, variable life, and whole life, contains a cash value account or an investment element to the insurance.

Rules of Thumb

The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts.

Tip: If the family cannot afford to insure both wage earners, the primary wage earner should be insured first, and the secondary wage earner should be insured later on. A less expensive term policy might be used to fill an insurance gap.

If one spouse does not work outside the home, insurance should be purchased to cover the absence of the services being provided by that spouse (child care, housekeeping, bookkeeping, etc.). However, if funds are limited, insurance on the non-wage earner should be secondary to insurance for the wage earner.

If your spouse could live comfortably without your income, then you will still need life insurance, but you will need less than someone who has dependents.

Tip: At a minimum, you will want to provide for burial expenses and paying off your debts.

If your spouse would undergo financial hardship without your income, or if you do not have adequate savings, you may need to purchase more insurance. The amount will depend on your salary level and that of your spouse, on the amount of savings you have, and on the amount of debt you both have.

Buying life insurance doesn’t make sense for everyone. If you have no dependents and enough assets to cover your debts and the cost of dying (funeral, estate lawyer’s fees, etc.), then insurance is an unnecessary cost for you. If you do have dependents and you have enough assets to provide for them after your death (investments, trusts, etc.), then you do not really need life insurance.

However, if you have dependents (especially if you are the primary provider as mentioned above) or significant debts that outweigh your assets, then you likely will need insurance to ensure that your dependents are looked after if something happens to you.

Evaluating Your Insurance Needs
A large part of choosing a life insurance policy is determining how much money your dependents will need. Choosing the face value (the amount your policy pays if you die) depends on:

• How much debt you have: All of your debts must be paid off in full, including car loans, mortgages, credit cards, loans, etc. If you have a $200,000 mortgage and a $4,000 car loan, you need at least  $204,000 in your policy to cover you debts (and possibly a little more to take care of the interest as well).
• Income Replacement: One of the biggest factors for life insurance is for income replacement, which will be a major determinant of the size of your policy. If you are the only provider for your dependents and you bring in $40,000 a year, you will need a policy payout that is large enough to replace your income plus a little extra to guard against inflation. To err on the safe side, assume that the lump sum payout of your policy is invested at 9%. Just to replace your income, you will need a $500,000 policy. This is not a set rule, but adding your yearly income back into the policy (500,000 + 40,000 = 540,000 in this case) is a fairly good guard against inflation. Remember, you have to add this $540,000 to whatever your total debts add up to.
• Future Obligations: If you want to pay for your child’s college tuition or have your spouse move to Hawaii when you are gone, you will have to estimate the costs of those obligations and add them to the amount of coverage you want. So, if a person has a yearly income of $40,000, a mortgage of $200,000, and wants to send his or her child to university (let’s say this will cost $80,000), this person would probably want an $820,000 policy ($540,000 to replace yearly income + $200,000 for the mortgage expense + $80,000 university expense). Once you determine the required face value of your insurance company, you can start shopping around for the right policy (and a good deal). (To find your estimate of insurance needs, Go to my Calculators page, click Personal Finance, and then click Life Insurance Needs Estimator. It’s about the fourth one down I think)
• Insuring Others: Obviously there are other people in your life who are important to you and you may wonder if you should insure them. As a rule, you should only insure people whose death would mean a financial loss to you. The death of a child, while emotionally devastating, does not constitute a financial loss because children cost money to raise. The death of an income-earning spouse, however, does create a situation with both emotional and financial losses. In that case, follow the income replacement trick we went through earlier (your spouse’s income/9% +  inflation = how much you’ll need to insure your spouse for). This also goes for any business partners with which you have a financial relationship (for example, shared responsibility for mortgage payments on a co-owned property).

Summary
If you need life insurance, it is important to know how much and what kind you need. Although generally renewable term insurance is sufficient for most people, you have to look at your own situation. If you choose to buy insurance through an agent, decide on what you’ll need beforehand to avoid getting stuck with inadequate coverage or expensive coverage that you don’t need. As with investing, educating yourself is essential to making the right choice.