Those who believe that life insurance is a necessary evil, also tend to believe that you should spend as little on it as possible. Often, this approach can serve you well. It is important to spend as little as possible on- or get the highest value from- your life insurance policy. In light of this, knowing whether you can afford a particular life insurance plan is critical information.
i) Life insurance premium servicing ratio
The debt-servicing ratio is used to determine whether you can “service” more debt with your income. In the same way, you should have a limit to the percentage of your income that should be spent specifically on life insurance. As a rule-of-thumb, if your aggregate life insurance premiums constitute more than 5% of your income, then you cannot comfortably afford more life insurance.
ii) Premium related to coverage
Whether you can get adequately covered on a plan is also a major consideration. Suppose you do a life insurance needs estimate and find that you need $1,000,000.00 in coverage. Using an actual example, the premium for this on a Universal Life plan may be $11,595.00 annually.
However, you only earn $60,000.00 annually. You cannot afford that particular cash-value life insurance policy because the premium related to the coverage is quite high; especially where short-term needs are involved. $1,000,000.00 on a Term to 65 life policy would cost only $2,260.00. That is a more affordable premium and allows you to access the coverage that you really need.
iii) Overall value
You have to link the premium to the value that you receive. For example, one life insurance plan may cost a bit more but contains several features or optional supplementary riders that are absent from another. The overall coverage is important because it would be prohibitively expensive to have additional stand-alone plans that cover income disability, health or accidental death instead of a comprehensive insurance plan with basic life insurance.
Generally, a stand-alone cash-value life insurance plan may offer less overall value. This would make it less affordable, since you would have other areas to cover. If you are considering a stand-alone life insurance plan, then a term life plan would normally be the most affordable given the one-dimensional nature of the coverage needed.
iv) Opportunity cost
Life insurance is not the only protection product that you require. It isn’t the most important risk-management product either. The opportunity cost of life insurance is the cost of the highest-valued alternative foregone. You have to save for retirement, purchase health coverage and cover myriad other financial needs. Whether you can afford a particular life insurance plan is dependent on how much it prevents you from comfortably covering your other financial needs.
It is best to use a multivariate approach to determine if you can afford a life insurance plan. Doing this would safeguard you against paying too much for it. The risks of thinking you can afford a hefty life insurance premium at the expense of other aspects of financial planning are too great.