Millions of Canadians have life insurance, but roughly 70% of them are not sure if their policy would give their family adequate financial protection.
So the most important question you should ask when shopping for life insurance is, how much coverage do I need?
In this article, we will explore the factors that impact how much coverage someone needs, and what you should look for when buying coverage.
How much life insurance do I need?
Your family is unique — your life insurance should be too. “One size fits all” doesn’t work in life insurance and there’s no easy answer to this question. The following three rules of thumb can help you determine how much life insurance coverage is sufficient for your family.
Remember, these rules don’t take into account some key factors, like your savings. Use our insurance calculator to get a better idea of your insurance needs and then compare that figure with these estimates.
Rule #1: Multiply your annual income by 10 (factor of 5 if money is tight.)
This is the simplest method for calculating your life insurance needs, but it has limitations. It doesn’t factor in your savings, nor does it take a comprehensive look at your family’s needs.
Also, it doesn’t work for someone who’s a stay-at-home parent. A stay-at-home parent needs life insurance just as much as a working parent, even though they don’t claim an income. If a stay-at-home parent passes away, the surviving spouse will need to hire someone to cover many or all of the responsibilities the deceased used to cover.
Rule #2: Multiply your annual income by 10 and add $10,000 per child for college costs
If you have children or planning to have them in near future, you may also want to factor in tuition costs. However, just like the “10 times income” rule, this one too doesn’t consider your family’s needs in detail, existing assets, or unpaid contributions made by a housewife or househusband.
Rule #3: The DIME formula
Among the three rules of thumb, the DIME formula is the most comprehensive. It ensures your life insurance covers four key areas: debt, income, mortgage, and education.
- Debt – How much debt would you want to leave to your family? This could include a student loan, credit card loan, or any debt that isn’t written off at death.
- Income – Consider the number of years for which your loved ones would need financial support. Then multiply your income by this number.
- Mortgage – Your mortgage doesn’t go away when you die so factor in your mortgage balance into your life insurance equation.
- Education – How much will your children need for a college education?
This DIME formula is a good starting point for determining your life insurance needs. But, like the other two, it ignores your existing financial resources and the cost of services that a homemaker provides for free.
How to calculate how much life insurance you need in Canada?
Here’s an example of calculating life insurance needs using the DIME formula.
Let’s say your total debt balance is $30,000. This includes everything from credit cards, lines of credit, car loans, and student loans. However, the mortgage is not included in it, as we’ll calculate this separately.
You may also want to add any future debts that you won’t be able to cover, like your funeral costs. Let’s say, you’ll need $12,000 to meet end-of-life expenses.
So your total debt now comes to:
Debt: $30,000 + $12,000 = $42,000.
Next, determine the number of years for which you want to provide income replacement for your loved ones. You can use the number of years until your youngest child turns 18, finishes college, or buys her first house. Alternately, you can consider the number of years until retirement — it’s your call.
Let’s assume you earn $60,000 a year. You would like to support your family until your youngest child graduates from college, which is about 20 years.
Income: $60,000 x 20 = $1,200,000
Now, calculate how much is left on your mortgage. Let’s say, you owe $450,000 on your home.
Total Mortgage: $450,000
How much money would you need to send your child to college 20 years from now? If you have more than one child, factor in the cost of a college education for all your kids.
For simplicity’s sake, let’s consider the maximum lifetime amount you can contribute to an RESP in Canada — $50,000.
Education (for one child) = $50,000
Considering the DIME formula, you’ll need 1,742,000 in coverage for 20 years.
Additional tips for calculating your life insurance coverage needs:
- In case you have a child with special needs, consider permanent life insurance. With a permanent life policy, you can rest assured knowing your family will receive the benefit amount, regardless of when you die. Term life insurance, for all its advantages, doesn’t offer this guarantee.
- In case you want to buy life insurance for end-of-life expenses, you don’t need to consider your debt balance or other expenses. A bare-bone life insurance plan will be sufficient.
- Don’t skimp on your life insurance. It’s better to buy a little more coverage than you believe your family will require than to buy a little less. After all, the last thing you would want is to leave insufficient money to your family.
What does life insurance cover?
People typically take life insurance coverage equal to 10-15 times their annual income. That allows them to cover most or all of the expenses mentioned below:
Everyday expenses and monthly bills
A life insurance payout should cover your monthly bills and basic living expenses, like groceries, utility bills, and clothing. Ultimately, it helps ensure your family can maintain their current standard of living without worrying about the lost income.
If you have long-term debts in your name, like a mortgage, they won’t pass away with you. After you’re gone, your family will have to deal with it. Without your income, this may not be easy. That’s where life insurance comes in. It can take care of any long term debt you’ve taken and save your family from financial hardships.
A life insurance payout can take care of all child care expenses you’re currently shouldering. This includes tuition fees, after-school programs, and more. If you have kids or planning to have them, consider factoring in college costs as well, considering how fast they are rising.
It’s not cheap to die. Costs associated with cremation, funeral homes, and headstones can run into thousands. On average, a burial costs anywhere between $5,000 and $15,000 in Canada. If you don’t want to burden your family with the cost of your funeral, factor it into your coverage.
What else should I consider when determining how much life insurance I need?
You may have heard bigger is better. But does it apply to life insurance as well?
The larger the death benefit, the greater the monthly premiums. While we all would like to leave as much money to our family as possible, we must be realistic. There’s no point in signing up for a $5 million life policy if you can’t afford the premiums without stretching your budget to the limit. Sooner or later you’ll miss payments, which may cause your policy to lapse. Nobody wants that.
It’s important you select a policy that provides adequate protection to your family but also fits your current budget. And often the best way to calculate how much life insurance coverage you may need is by asking the intended beneficiaries how they plan to use the payout.
Once the insurer pays out the policy proceeds to a beneficiary, they are free to use the money any way they like. They can use the payout to settle a large debt or cover everyday expenses or both. If they want, they can even set the money aside for higher education or charity. In short, there’s no right or wrong way to use a death benefit amount.
However, talking to your loved ones about how they are likely to use the payout would help you understand how much life insurance you might need.
What kind of insurance should I get?
The two main types of life insurance are term or permanent. Term life insurance plans cover you for a limited period. Permanent life insurance, as the name suggests, has no end date. It covers you for your entire life.
What kind of life insurance plan you need depends on your personal and financial circumstances.
Do you want protection until you retire or your children become financially independent? Do you need a life insurance policy to cover your mortgage?
If so, consider term life insurance. This type of life insurance plan is suitable for financial obligations with an end date.
Do you want to buy life insurance on a budget?
Then term life insurance may be a good fit for you. Premiums for a term life policy are significantly lower than those for a comparable permanent life policy.
Do you have a child with special needs? Do you have a lifelong dependent?
In that case, permanent life insurance may be a better choice. It doesn’t come with an expiry date. That means your loved ones are guaranteed to receive the death benefit amount upon your death, whenever that may happen.
Do you want a life insurance policy to cover end-of-life expenses? You may want to go for permanent life insurance with a small payout.
How much does term life insurance cost?
Many factors impact the cost of life insurance, like your age, gender, and health, and the specifics of the policy you pick. For a healthy person in their thirties, a 20-year term policy with a $400,000 payout may cost around $20 a month. That’s less than the cost of a cup of coffee a day!
You may not be able to pinpoint how much life insurance coverage you need down to the penny. However, with the right insurance calculator, or having conducted a needs analysis with a certified insurance broker you can easily get a good estimate of how much protection your family needs. Adequate life insurance cover, in turn, ensures your loved ones will be able to live comfortably when you’re no longer there to provide for them.
- What if I have life insurance through my employer?
If your employer benefits offer life insurance coverage, get it if it fits your financial situation as it is usually offered at a discount. However, think twice before relying on it as your only coverage.
Typically, group life plans have small death benefits, one or two times your annual salary. That is likely to be not enough to send the children to college, clear off the mortgage, and support your family for much time.
Also, you always can’t take employer-sponsored coverage with you. The coverage may end when you leave or lose the job. And if your new employer doesn’t provide life insurance, you could be in a tricky spot, especially if you developed a medical condition over the years. You may no longer be able to qualify for personal life insurance at affordable rates. For this reason, it’s best to have life insurance early in life. Premium rates increase as you grow older.
Furthermore, group life policies are one-size-fits-all. They don’t allow the customization some people need. So, it’s possible the free life insurance policy may not fit your unique situation.
Given the limitations of the employer-sponsored life plan, it’s advisable to pair it with a personal life insurance policy to ensure your family is adequately protected.
- Do both my spouse and I need life insurance?
The answer is YES. Both you and your spouse should consider a policy, even if your partner is a homemaker.
Think about the services your non-working spouse provides for free — caring for young children, cleaning the house, cooking meals, running errands to name a few. If the unthinkable happens, you may have to hire someone to perform many or all of the jobs that the stay-at-home partner takes care of. And that could create a significant financial burden on you.
For instance, the average hourly rate for a nanny in Canada is in the range of $15 to $20 (could be drastically higher if you live in Toronto or Vancouver). Even if you consider the bottom number, the childcare cost comes to nearly $600 a week or $31,100 a year. Multiply the expense over several years and it’s clear why homemakers need coverage.
- What if I need to change the coverage later on?
As time goes by, many things change. Your hairstyle, musical taste, metabolism, and even life insurance needs. Perhaps you’ve now saved enough for your kid’s college education and need less coverage. Or maybe your financial needs have become greater and you want more coverage.
Typically, it’s easier to reduce the coverage amount on your policy than increase it. Whether you can reduce the value of your life insurance policy or not depends on your insurer. Some providers allow policyholders to lower the level of coverage, some don’t. Also, companies that allow you to reduce your coverage usually have restrictions on when and how often the policy can be modified.
If you want to increase the coverage amount, most likely you’ll have to reapply and go through the underwriting process again.