Life insurance is a necessity if your family depends on your salary for housing expenses, servicing debt, and general living. But how much life insurance do you need?
In 2014, a BMO Insurance study found 74% of Canadians had a life insurance policy, but 70% weren’t confident their policy would give them enough to take care of their family if they passed away. So when you ask ‘How much life insurance do I need’ – you’re not alone.
NOTE: If you have a workplace life insurance policy, it usually only covers 2 years of your salary, which is a bonus, but likely not enough life insurance as you'll see below.
How much life insurance do I need?
There’s no quick answer to how much life insurance you need – your financial situation is different than your siblings and co-workers, so take the time to figure out your situation. A rule of thumb is to make sure your life insurance covers your debts, income, mortgage, and education. This is called the DIME formula.
- Debts: How much do you have?
- Income: The lost income that would need replacing.
- Mortgage: The amount remaining on the mortgage.
- Education: How much your kids will need for post-secondary learning.
Let’s break it down with a real-life examples, to better understand how much life insurance you need.
The simple life insurance needs calculation
We’ll start with how much debt you have, not including your mortgage. This includes any credit cards, lines of credit, car loans, and any student loans. If you expect to go into extra debt in the near future, make sure to include that as well. You’ll also want to include future debts you won’t be around for, such as funeral costs.
For a real-life example, let’s say you have $25,000 in debt and your funeral estimate is $15,000.
Debt: $25,000 + $15,000 = $40,000
Next, we need to calculate how many years your family would need your support, and multiply your annual salary by the required years. The number of years can be until your child graduates high school, leaves university, or buys their own house – this is up to you.
Let’s say you make $50,000 per year, and want to support your family until your children graduate college. Let’s estimate that’s around twenty years.
Income: $50,000 x 20 = $1,000,000
How much do you owe on your mortgage? You’ll want to life insurance coverage for the entire amount. You might even consider adding more to cover the costs of a major renovation, in case your family outgrows your current house.
For this example, we’ll say you have $400,000 remaining on your mortgage, but you want expect to add a granny flat in the next five years, at a cost of $50,000.
How much will it cost in twenty years to send 2 kids off to college? What if they end up wanting to do their masters, PhD, or even a college diploma? Will they study at home or abroad? These are all costs you’ll want to have covered. To make our number easier, the lifetime limit of an RESP for any beneficiary in Canada is $50,000.
For two kids, each with maxed out RESP’s would be $100,000.
Education = $100,000
If we use the DIME formula, in this scenario, this person would need $1,590,000 in life insurance coverage for a 20-year term. Now, you just need to get some life insurance quotes.
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Another way is to manually calculate your life insurance needs. First, you can add up financial obligations. Ok, I'll ask that you break out your phone's calculator and maybe a piece of paper to write down your totals. The brain remembers things better when we write them down.
Does anyone depend on you financially?
If yes, get life insurance and simply follow the formula below to figure out how much life insurance you need to get.
If not, you likely don't need life insurance. However, if you're in a unique health or financial situation, it's easy to compare life insurance quotes with us.
How much income does your family need to replace if you're no longer around?
You can either write down your annual after-tax income, but it's probably better to calculate expenses like meals, cars, clothing and services your family may need if you're not around like child care, house cleaners, and home repairs.
How many years do you think your family will need with your income?
Eventually the mortgage is paid off and RESPs are funded and your family can sustain themselves on their own. Multiply your answer from #1 with your answer to #2.
How much debt do you currently have?
Include your mortgage, car loans, credit cards, and any other personal loans. While they may only use a portion to pay down the mortgage to a manageable level for your spouse, other debts should be cleared.
How much money do you want for your kids' university education?
The average annual cost of Canadian Universities is $22,000 and $11,000 for those living at home. That number is expected to increase to $31,000 for 2038.
What kind of funeral do you want?
Personal preference plays a big role in how a funeral will cost. If you're getting cremated and a small service, you might pay around $1,500. But a grand event with many people could cost as much as $20,000.
How much money do you have in savings and investments?
You can subtract the total savings from your running total. Your family can liquidate your investments, too (or choose to keep them for their annual returns).
How much life insurance do you have?
Sometimes parents may have purchased a policy for you when you were younger and it could be paid off now, or you're making small monthly payments. You can subtract this amount from your running total.
How much annual after-tax income does your family have with your spouses salary?
Your spouse will continue earning. We calculated the household expenses in step 1,, so take this number and multiply it by step 2 and subtract it from your total.
Do the math
Step 1 multiplied by Step 2, then add Step 3, 4, 5. Once that's done, subtract Step 6, 7, 8. How much life insurance do you need?
How much is a 20-year term life insurance policy?
A rough estimate would be about $30-$60 per month, but it's cheaper if you're younger, in good health, and a female. Your term life insurance quote will likely be different based on a number of variables.
Another way to calculate: 10 x your salary
The old rule of thumb was 10 times your salary, but that’s arbitrary. You could calculate the salary you’d make until you retire and your family would certainly be comfortable, especially without your expenses (extra car, mouth to feed, clothing, vacations, etc.).
But, for simplicity, If you’re forty years old, making $50,000 per year and plan on retiring at 65, let’s do the math. 25 x $50,000 = $1,250,000. Your spouse could likely even retire with that money, especially if it's in the market and they're safely withdrawing at a rate below market appreciation.
Of course, we haven’t taken into account any high-interest savings or investment accounts like RRSPs that you would subtract from that total.
With that in mind, follow this 2 step process; essentially, financial obligations minus liquid assets.
Obligations: Annual income multiplied by the years you want to replace that income, then add in your remaining mortgage, debts, college funds and funeral expenses. If you’re a stay-at-home parent, include how much it might cost to replace all the work you do every day from daycare to cooking and cleaning.
Liquid assets: What’s your obligated amount? Now, subtract your savings, investments RESPs, and any other life insurance you might currently have that maybe your parents bought for you when you were a child.
That number is probably not bad an estimation for how much life insurance you need.
There’s also an argument to buy multiple term life policies. Here’s how that would work. Let’s say you buy a 30-year term policy to only cover what your spouse needs until your retirement. Then, for your children, buy a smaller term say for 20 years to cover your children’s college education. If your life insurance quotes come to less, use it.
Workplace life insurance
If you have life insurance through work, the amount you’re covered for is usually one or two times your annual earnings. However, that might not be enough – the Canadian Life and Health Insurance Association says a common amount of coverage is often between five and seven times your current net income. What happens if you get fired or move to another company that doesn’t have life insurance? It’s better to have too much life insurance than not enough.
- Use the DIME method
- Speak with your spouse – would they need your full income or be fine with a portion?
- Consider a child-rider – insuring your children is often an inexpensive addition to your policy.
The Bottom Line
So, How much life coverage do you need? Well, it depends. It depends on what you want to leave your loved ones when you’re no longer here. What level of comfort do your loved ones require to carry on with their lives?
Remember, life insurance isn’t for you, it’s for them.