According to many experts, the best way to decide how much insurance you need is by performing a “needs analysis”. This isn’t as complicated as it sounds and while it will take you longer than multiplying your salary by seven, it’ll give you a much more accurate result.
Step One: Short-term Expenses
These fall into three categories—expenses that would need to be paid if you died (including medical, funeral, and legal expenses), your outstanding debts, and emergency expenses (such as for emergency medical treatment or unexpected car repairs).
Step Two: Long-term Expenses
Your long-term expenses include the balance on your mortgage and college tuition for your children. If your kids aren’t yet at college age, estimate their tuition costs by finding out current annual education costs. Then add five percent per year for each year until they attend college.
Step Three: Day-to-Day Expenses
These are the expenses involved in family upkeep, such as food, utilities, entertainment, travel, and clothing. Calculate one year’s worth of expenses, then multiply that figure by the number of years you want your insurance to provide this level of income.
Step Four: Financial Resources
Next, determine what resources you currently have to meet those expenses. This includes your current salary, savings, investments and any existing insurance you have, as well as Social Security. Do not include the sale of any assets that would change your family’s lifestyle if they were sold, such as your home.
Step Five: Add it Up
Add your totals from steps one to three. Then subtract your resources calculated in step four from your expenses total. The figure you end up with is a good estimate of the amount of life insurance you need.
Don’t be discouraged if you end up with a much higher figure than you were expecting, or can afford. If this happens, run through your calculations again and try to find ways to cut expenses. For example, by paying debts early you can reduce your short-term expenses.
Because your insurance needs will change over the course of your life, experts recommend that you review your insurance every three years to ensure that you’re adequately covered.