Rules of thumb can get you into trouble when you’re investing, buying a house or setting up your budget. But rules of thumb are especially risky when it comes to buying life insurance.
If you make a mistake with your budget, you can fix it. Make a mistake with your car purchase, and you can refinance, earn more money or use lemon laws to rebound. Make a mistake with life insurance? Someone has passed away, and the heirs are left with not enough money, or you spend too much money on insurance you really didn’t need.
Because insurance is important when you have a family, there’s a better way to find the right life insurance amount — and it only takes three steps.
[See: 9 Ways to Reduce Your Insurance Costs.]
1. Ask yourself what would happen if you passed away. Does someone you love or a group (maybe a charity) need income on an ongoing basis or a lump sum of money? How much? Are there bills that will need to be paid immediately? How much are those?
Once you know how much money people and organizations will need when you pass away, then it’s a simple math problem to calculate how much of a lump sum today you’d need to reach that goal. This is a part of avoiding rules of thumb that can trip people up, but it isn’t difficult. By taking just a few minutes to add together the amount of money your heirs will need, you’ll know you’re well on the way to buying the right amount of life insurance.
[See: Dear Younger Me: 12 Financial Truths We Wish We Knew Earlier.]
2. Review your assets. Take a moment to determine how much of the amount your heirs need is covered, and for how long. While you may have enough money to cover your sudden death, that money may not be in the right place to access. That’s why some people choose to still have life insurance, even though they have plenty of assets. If your net worth is locked up in illiquid assets such as real estate or a business, you may still want to buy life insurance to cover short-term needs, even though you may be technically “covered.”
[See: 10 Costs Homeowners Insurance Doesn’t Always Cover.]
3. Consider the type of life insurance you need. If you don’t have enough assets, then decide which type of life insurance works best for your situation. In many cases, term life insurance is the right answer. If you have circumstances that show you’ll need insurance late in life, then you’ll need to begin digging into how permanent policies work.
Term insurance is best for short-term needs because the cost of every thousand dollars of coverage is lower than that of permanent insurance. Why? It’s not because permanent insurance companies are gouging you for more money. Permanent insurance is more expensive because it’s guaranteed to pay when you die, so the insurance company needs to recoup that cost. Term insurance becomes more expensive when the company thinks you’re going to die. Because people cancel the policy at that point, term insurance is generally much cheaper to purchase, for the sole reason that you’ll probably (and hopefully) never use it.
Isn’t that a better way to buy life insurance? Using three easy steps, you’ve just avoided the huge pitfalls of using just a rule of thumb. While these can put you in the ballpark of the right amount of insurance, using these three steps above will not only give you more assurances that you have the correct amount, but it will also help you more confidently choose the right type.
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3 Steps to Buying the Right Type and Amount of Life Insurance originally appeared on usnews.com
