A detailed calculation of your life insurance needs will require two equations that you may have picked up in Finance 101: the future and present values of money equations. The future value of money equation tells you how much your money will be worth in a given number of years while earning a given rate of interest. This equation is essential if you are calculating how much money you'll need in the future because of inflation, or what your death benefit will be if you choose to invest the money at a given interest rate. The present value of money equation tells you what your money is worth before it has been invested for a given number of years at a given rate of interest. This is important if you have an amount of money that you need to have in the future, and you need to know how much life insurance coverage you should buy now to invest it at a given rate of interest at a given number of years. If this sounds complex to you, don't fret. As long as you have a calculator (preferably a financial calculator, which is used by accountants and finance professionals), these equations are no sweat.
Here's how the future value of money equation works: Say that average college education costs are $20,000 annually for a private four-year institution, and you want to figure out how much it will cost in four years if college costs keep going up 5 percent per year. You would multiply 20,000 by 1.05 (1 represents the present cost, and .05 is 5 percent inflation) four times (or 1.05 to the fourth power). So your equation would be this: 20,000 x (1.05)4 or 20,000 x (1.05)(1.05)(1.05)(1.05) The answer is $24,310.13. Many experts say the best way to pinpoint a smart life insurance figure is through a needs analysis, which can be broken down into a simple formula: Short-term needs + long-term needs - resources = how much life insurance you need. This method is "probably the most accurate approach in what is an inaccurate and imprecise science." They further advise that you do an analysis at least once every three years, or whenever you have had a major life change. For example, if you have a new baby, you have to recalculate college education needs and child-care costs. If you own a home, a mortgage is likely your biggest financial burden. Because your mortgage balance decreases with each payment, it's important to include those revised figures in your calculations. A life insurance agent is trained to help you determine which of your financial needs are fixed, which will grow and which will diminish using the "needs analysis" tool. Five steps to a needs analysis Step 1 Add up all of your short-term needs. These can be placed into three categories: final expenses; outstanding debts; and emergency expenses. Among final expenses are medical, hospital, and funeral expenses, attorney or executor fees, probate court costs (if you do not have a will), and any outstanding taxes that would need to be paid if you died. Among outstanding debts are credit card balances, auto loans, college loans, and all other outstanding bills. Emergency expenses should include a cash reserve for medical emergencies and repairs to your home or car. Calculating final and emergency expenses can be complicated, because you don't have a crystal ball that tells you how much your medical or hospital expenses will be, or if you even will have any. Experts recommend that you allocate 50 percent of the higher wage earner's salary for the final expenses part of the calculation, and three to six months worth of living expenses as your emergency expenses. Step 2 Next, add up your long-term debts, which include your mortgage and college tuition (the latter two only if you have children). For your allocation to your mortgage, put down the balance. Calculating an education fund is tricky because you have no idea where your children will be going to college. Perhaps the best method is to use the present average college cost in the United States and the number of years away your children are from entering college. The average college costs for the 1999-2000 school year were $8,086 annually for a public, four-year institution, and $21,339 annually for a private, four-year institution, according to The College Board. Vance Grant, an education statistics specialist with the U.S. Department of Education, says that college costs traditionally have been rising at about 5 percent annually, so you need to figure out what the cost will be when your child goes to college. (To calculate what costs will be in the future, go back to the future value of money equation. Also be sure to calculate what the entire education will cost while taking into account the increased costs each year.) Step 3 Next, calculate family maintenance expenses. These include such necessities as child care, food, clothing, utility bills, entertainment, travel, and transportation. Calculate this figure based on a year's worth of expenses, then multiply that times the number of years you want to provide this income. Once you've done that, add your short- and long-term debts and your family maintenance expenses. Step 4 Now that you've tallied all of your income needs, figure out what resources you have to meet them. To do this, add all available savings, stocks, bonds, mutual funds, existing life insurance (such as group life through your employer), and Social Security. You and your spouse can find out how much you'll get through the Social Security Administration (SSA) by visiting the SSA's Web site , where you can get an estimate of how much you should have in Social Security benefits. Also add your present salary, and assume 5 percent compounded interest each year if you expect salary increases over time. You should count only liquid assets (those that could be quickly converted to cash) among your resources. You shouldn't count items such as your home or automobile, because selling them for cash when you're gone would mean changing your family's lifestyle. Step 5 Subtract your resources from your total expenses. The figure you get should represent the amount of life insurance coverage you should buy. Don't be alarmed, the final figure that shows how much life insurance a person needs can be quite frightening. If you end up with a huge figure that requires an enormous premium, go through the analysis again and select areas where you can allocate less money. If the final figure still causes you to say "Gosh, I can't afford that", keep making adjustments and remove any expense items that aren't crucial to maintaining your family's well-being. |
