Life Insurance Tips

Most people don’t understand the purpose of life insurance, which is why they end up with the wrong type of coverage, no coverage at all, or the wrong amount of coverage. Life insurance is supposed to replace the income or the productivity of the insured to minimize the financial loss to their survivors. I emphasize financial loss of course because no amount of money can replace the emotional loss suffered from the death of a loved one.

Any family member whose income is used and needed by the family should be insured. And any family member, such as a non-working spouse, who provides some type of productivity around the house such as caring for the children or general home-care, even if they have no income, would need enough insurance so the surviving spouse could maintain a similar level of care. For instance, a baby-sitter or half-day daycare may now be needed, as well as someone to help maintain the house once per week.

Of course I keep referring to family member, but it really is any two people who commingle assets. So if two people purchase a home together for instance, and they are relying on both incomes to pay the mortgage, then it makes sense that each has enough of a policy to take care of half of the house. Otherwise you will be leaving your partner high and dry.

Since the purpose of life insurance is to replace income, there is little point to having insurance on a child. At least not on a young child without a job or whose income is not being used to support the household. There are some instances where an adult child may financially support siblings or elder parents. In this instance it would be a responsible thing to insure that individual.

But how much life insurance do people need? The standard rule of thumb is that you need 8 to 10 times your annual income. The reason once again is that you are trying to replace your income. So if you make $50,000 per year, your family would need about $500,000. This is money they would invest or use to purchase an annuity and use the interest or earnings from that money as an income replacement. Alternatively, you could use a portion of that sum to pay off any debt and then invest the remainder. You will earn much less each year, but then your bills will be much lower without the mortgage and credit card bills, and so on. This amount of money will not replace 100% of your income, but should be enough to handle the remaining expenses.

For a non-working spouse, you should estimate the amount of money it would take to replace his or her productivity and multiply that by 8 or 10 as well. Of course, you have to determine how long you would need that productivity. If you have one child age 17 that will be leaving the home soon, then you have much less need than if you have three children all under the age of six, then you may be looking at a lot of day care over the next 16+ years.

If you are dealing with a non-married couple who maybe just shares a house, then you may simply want enough life insurance to pay off your half of the home. But don’t buy credit insurance or mortgage insurance – that goes against the rule of buying the broadest coverage possible.

One other thing to point out. The concept of life insurance is that it replaces your income. If you have a very large 401K that can be used by your survivors in the event of your death, then you may need very little or no life insurance at all. In fact, as your 401K (or IRA, etc.) grows, the less need you will likely have for life insurance. If you are not investing much and you have a large amount of debt, then your need may be greater.

Now some of you may be thinking that $500,000 or more in life insurance is just not achievable or affordable. But you would be wrong. Since the only type of life insurance policy people should be purchasing is term insurance, it is not very expensive at all. A healthy 40-year-old man can get a half million dollars of 20-year level term insurance for about $40-$50 per month. That’s significantly less than most family cell phone plans or cable bill. A woman of the same age can get the same amount of coverage for about $5-$10 less per month. Of course the younger you are when you purchase the insurance, the less you will pay each month.

To keep your budget on target and keep your family protected, don’t be confused by the multitude of policies available such as cash value, whole life, etc. The only people who ever seem to think those really expensive policies are worthwhile are the people who make the really large commissions selling them. Remember, you are purchasing life insurance to protect your survivors from your loss of income. I probably sound like a commercial, but term insurance provides the coverage you need at a price you can afford.

(Don’t forget to check out the Money Matters TV segments the 1st, 3rd (and sometimes 5th) Tuesday of each month. The videos are posted right here on The Money Professors blog.)

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The three authors, Bill Pratt, Mark C. Weitzel, and Len Rhodes, are industry leaders in personal financial education. Together, they have a combined 75 years of experience in banking, economics, and entrepreneurship. Now, they teach thousands of students personal finance concepts and decision making skills, author textbooks and public press books on personal finance, and help schools develop innovative personal finance literacy programs. Recently, they were instrumental in developing a personal financial management certification program for leaders in higher education. The other books in The Money Professor series include The Graduate’s Guide to Life and Money and Extra Credit: The 7 Things Every College Student Needs to Know about Credit, Debt & Ca$h. Their books, lectures, and programs give students, parents, and educators the tools and knowledge to make good financial decisions all their lives.