How Much Life Insurance Do You Need
Insurance is an important tool of risk mitigation and a critical aspect of financial planning. Life insurance allows an individual to ensure that his loved ones and financial dependents can continue to lead a decent life and meet their expenses.
Life insurance is an agreement between an individual and a company to provide financial compensation in case of death of an individual in return for payment of a specified premium.
Sadly, most life insurance products are sold as investments/savings instruments and tax savings options. They are neither of them. Life insurance is a Risk Mitigation instrument to provide for your financial dependents. Nothing more.
So how much life insurance do you really need? There is no magic number that suits everyone. Like everything else in financial planning, the cover required is dependent on individual circumstances and requirements of their dependents.
We follow our calling, passion and professions to earn a living and provide for our loved ones. No matter what our income levels are, we earn so that our families can get the best living, enjoy the best facilities, get good education and travel to places that fascinate us.
But we fail to estimate what happens if that income stops suddenly. Will our loved ones be able to live the same quality of life, do they have alternate sources of income and if no, how soon can they get back to earning the same kind of income.
How to arrive at the required life insurance cover?
Two popular ways of arriving at Life Insurance Requirements are Income Replacement Method and DIME Method. Let’s look at each of them.
Income Replacement Method
When the primary earner for a family dies, the family goes through a financial shock. When analyzing the amount of life insurance cover required you can look at below important pointer;
Your Annual Income
What is your annual post tax income from all sources? If you are salaried, look at your EPF and other mandatory deductions that get invested. Consider only those income where the income is solely dependent of your capacity to earn. For instance, passive incomes like rental and royalty income will continue even in your absence.
Active working Life
One needs to assess for how long they will continue to work. If one as estimated that they will retire by age 50, they will need to consider their income generation only till that age. If you are 30 years old now, you will have to factor in an active working life of 20 years in this case.
The DIME Method
DIME stands for debt, income, mortgage and education. The method has you add up these amounts:
- Debt:How much debt would you leave to other people? This could include credit card debt and student loans that aren’t forgiven at death.
- Income: Multiply your income by the number of years you want to provide income replacement for your family. Number of years until your youngest child turns 24.
- Mortgage:Add your mortgage balance to your running total.
- Education:Add an amount that covers tuition, room and board for each of your children who will go to college. The College Board regularly publishes trends in college pricing.