Life insurance is a crucial purchase for anyone with people depending on their income or relying on them for help and support. But it can be complicated to figure out exactly how much insurance protection is necessary to provide for loved ones after a policyholder’s death.
The good news is, there are simple formulas out there that can help people estimate the necessary amount of life insurance coverage in mere minutes. In fact, this basic advice from personal finance expert Dave Ramsey can make it very easy for anyone to get an idea of the amount of life insurance coverage they’ll require.
Ramsey’s solution to estimating life insurance needs is simple
Ramsey advises the purchase of term life insurance and specifies that people should generally buy an amount of coverage equaling 10 to 12 times their annual income.
Term life insurance is a type of coverage that is in effect for a pre-designated time period called the coverage term. That term is usually between 10 and 30 years, although there’s flexibility in how long insurance carriers provide coverage. If a policyholder passes during the coverage term, then the life insurance company pays a death benefit. If they don’t, then no benefits are paid from the policy. Ramsey believes that a 20-year term is a good coverage time period for most people.
Policyholders get to decide how large their death benefit should be, which is where Ramsey’s advice to buy a policy worth 10 to 12 times their annual income comes in. If his suggestion is followed, someone making $50,000 annually would buy a life insurance policy with a death benefit worth $500,000 to $600,000. “When that money is invested well, your family can live comfortably on the return of that investment,” he explains.
His advice is common among financial professionals, many of whom suggest choosing a death benefit amount equal to a multiple of annual salary. And there are certainly some advantages to this approach — namely, its simplicity.
Of course, this is a generalized approach that may not necessarily be enough to provide sufficient coverage for every single person. Someone who has a lot of debt, a large mortgage, or a large number of children who they want to pay to educate may find this is an insufficient amount of life insurance to fully protect their families.
Other approaches, such as using a life insurance calculator that takes personalized needs into account, could be helpful in ensuring everyone gets sufficient protection for their unique situation. The DIME formula could also be helpful. It suggests buying a death benefit large enough to:
- Pay off debt (the D in DIME)
- Replace a certain number of years of income (the I in DIME)
- Repay a home mortgage (The M in DIME)
- Cover educational costs for children (The E in DIME)
Still, for those with fairly standard obligations or who don’t want to go through the effort of completing a formula or using a calculator, Ramsey’s advice is a straightforward and fast way to determine the necessary amount of coverage. It’s likely good enough for most consumers.
Source: The Motley Fool