It may be the last great act of love that you can ever perform for your family — if you die an untimely death, a good life insurance policy effectively allows you to care for your family financially from beyond the grave.
The unfortunate truth of human existence is that it is temporary. Each of us is going to die someday; the only question is when. And though our average life expectancy extends well into our 70s, that’s no guarantee. There are a host of risk factors in this world that threaten to cut your life short at any time. And that means that in addition to being spiritually prepared to meet your Maker, you also need to be financially prepared to handle the consequences of an unlikely death.
In this series, Understanding Insurance, we’ve been studying some of the fundamental concepts of insurance and seeing how they apply to our financial lives. We’ve already covered health insurance and auto insurance, and talked about ways to reduce your risk factors and your insurance premiums. Today’s discussion is about life insurance, one of the most important purchases that you can make for your family.
Who Needs Life Insurance?
Do you have any dependents — anyone in this world who counts on you to provide for them? If so, then you probably need life insurance.
If you earn an income that provides money to take care of your family, and you die tomorrow, what happens to your family financially? They may get a little bit of a benefit from Social Security, but it’s not going to be enough to make up for the loss of your income. That’s what life insurance is for. We buy life insurance hoping that we never need it, but knowing that in case something terrible happens to us, our families will be protected financially.
How does life insurance work? We’ll let’s say that you buy a $100,000 policy on your life with a 10 year term. If you die within 10 years from the time that you bought the policy, the beneficiaries of your policy (usually your next of kin) get a check for $100,000. That money can help to cover the costs of a funeral and other end-of-life expenses, and it can also go toward meeting the needs of your family in perpetuity.
Some people (often insurance salesmen) teach that everybody — even children — should have life insurance policies. I don’t subscribe to that idea: A good emergency fund should allow you to cover the costs of a child’s funeral should such a tragedy occur. Instead, I believe that life insurance is most important for adults with dependents. If you’re a single adult, you probably don’t need life insurance. But if you’re married, then you need a policy to protect your spouse and children in case you die.
What Kind of Insurance to Buy
There are a lot of different kinds of life insurance out there, and unfortunately most of them are not great deals. Some people disagree with me on this, but I’m fairly insistent: The only kind of insurance that makes financial sense is term life insurance.
Term life insurance is simple and cost effective. When you buy your policy, you select the term that it will cover — usually 10, 20 0r 30 years. If you die within that time, your family gets paid the face value of the policy. If the term expires while you’re still alive, then you can sign up for a new policy on a new term.
Term life insurance is very affordable — usually just a few dollars per month for every $100,000 in coverage. The shorter the term of your policy, the less expensive it’s going to be (because the chances of you dying in the next 10 years are much smaller than the chances of you dying in the next 30 years). On the other hand, a long-term policy locks in your rates for decades; short-term policies will gradually become more expensive as you age.
Term life insurance is great because it protects your family during the years when they can least afford to lose you — i.e., your working years. If you’ve stayed out of debt, saved and invested well, however, you should have a strong portfolio by the time you retire (say 65 0r 70 years old), and your family can live on the returns from that money after you die. This means that you don’t really need insurance when you’re 70 years old — by that point, you’re basically self insured. Term life insurance is very compatible with this approach.
Unfortunately, there are a lot of other life insurance plans out there based on the idea that you’ll need insurance for your “whole life.” These plans usually mix standard insurance products with investment products. They can sound attractive, but the truth is that they usually make an expensive way to insure your life and an expensive way to invest. I don’t recommend whole life, universal life or other such policies for this reason. Term life insurance is the way to go.
How Much Insurance to Buy
So, you’re getting ready to buy term life insurance — how much do you need?
Probably a lot more than you think. The best strategy with insurance is to buy enough to replace your income should you die. Let’s say that you earn $50,000 each year that your family counts on. If you die and you have a $50,000 insurance policy, that replaces your income… for all of one year. It doesn’t go very far. So what we need to do is find an amount of insurance that will replace your income in perpetuity.
Here’s how the strategy works: You want enough insurance that your family can get a huge payout, then put that money into a mutual funds that will pay out a certain amount of money every year. You want that amount to replace your income on a yearly basis. Since good mutual funds return an average of 10 percent or so each year, you ideally want a life insurance policy that is worth 10 times your income — or $500,000 if you make $50,000 each year. That way, your family can invest the large amount and the 10 percent return off of that investment replaces your $50,000 income.
If you have a house with a mortgage, you may want to add the balance of your mortgage to the value of your life insurance policy — that way your surviving spouse could pay of the house immediately when you die, and then use the balance of the payout to invest for income replacement. This is a much more economical option than opting for the “mortgage payoff” insurance that mortgage companies sell. Skip their expensive insurance and add the value of your home into your regular insurance policy.
There are a lot of subtleties to life insurance, and your individual decisions will depend on your unique life circumstances. You should work with a good insurance agent that you trust in order to set up the insurance plan that will be best for your family.
Photo by Jonelle B. Used under Creative Commons License.