How to Buy Life Insurance Wisely

Last Updated Sep 30, 2009 11:21 AM EDT

Dave and Vicky have a common problem. They're dual income parents with a young child and practically no

life insurance. They think they need at least some insurance to protect their family's economic well being in the event one or the other were to die, but they don't trust the claims of the insurance agents they've talked to and want to understand how to determine how much insurance they need and what kind to buy.

To help them, and anyone else in a similar situation, here are five steps to buying life insurance wisely.

Step One: Determine If You Need It.

The purpose of life insurance is to protect the economic well being of your dependents if you die. If you don't have anyone who depends on you for financial support, you don't need it. If you have lots of assets that could be tapped to protect the income and lifestyles of your dependents, you also may not need it.

But if you have few assets, lots of debt and dependents, you may need a lot. Life insurance is designed to fill the gap between what your dependents would have and what they'd need if you were to die unexpectedly.

Step Two: Pick a Type

There are two types of life insurance--term and whole life.

Term is the easiest to understand. It covers you for a set period, usually a year. If you die during that time, your heirs are paid the face value of the policy.

Because there is only a slight chance that you will die in any given year, particularly when you are young and healthy, term insurance is cheap when you're young but gets progressively more expensive as you age. By the time you're in your 80s, it can be prohibitively costly. On the bright side, most people don't need insurance when they're in their 80s because they've built up enough other savings to protect their heirs--or their heirs have become older, more independent and no longer need economic support.

Whole life insurance is written with the assumption that you're going to keep the policy for the rest of your life. Insurers deal with the higher chance that you'll die while insured by charging more for coverage in the early years. That additional money builds up a savings account to help pay the death benefits when you die.

Because whole life is so costly in the early years--often four or five times as much as term insurance--its hard to buy enough to adequately insure a young family. In addition, it's a relatively rare family that needs insurance for their entire life.

Whole life is generally good for people who have an unusual situation--a family business; a disabled child; or some other unique situation that demands economic support for heirs forever.

Everyone else should buy term.

Step Three: Figure the Right Amount

Pull out a pencil and pad and start jotting down your assets and debts. Then go through your annual budget and determine how much of your annual expenses are handled by each spouse's income. If one spouse takes care of the kids, consider how much it would cost each year to replace that spouse's work with paid help.

Now think about how either of you would fare economically if the other spouse were to die. Would there be a gap between the survivor's income and obligations? Would the survivor be saddled with a ton of debts?

If you have a gap between the annual income the survivor would have and what would be needed, determine approximately how many years that gap would persist. Multiply the gap by the years to come up with a rough estimate of how much insurance you'll need; then add in any big debts--maybe your mortgage or the estimated amount that you think the kids would need for college. Finally, round up to the nearest quarter-million. In other words, if you think you need $350,000 in coverage, round up to $500,000. If you're buying term coverage, it's cheap and better to have too much than too little.

Step Four: Shop

If you've got an insurance agent that you like, call him or her and get a quote. If you are dealing with an independent agent, they're likely to get you quotes from several companies.

You should take a few extra minutes and shop on the web too. There are a half-dozen web sites, including Accuquote. InsWeb and Insure.com. which offer fairly simple comparison shopping, so you can make sure you're getting a competitive rate.