To illustrate how important this is, I need to digress on the concept of Present Value (PV). PV is simply today's value of any item. For any dollar amount now, its PV is simply today's dollar amount. For dollar amounts in the future, to convert that into today's dollar amount, the PV, you must "discount" the future dollar amounts by some rate of interest. This makes sense, because you could place today's dollars in a risk free savings account or investment such as T-bills, and they would be augmented by that rate of interest to grow into tomorrow's dollars. There are complications such as taxes, uncertainties in interest and inflation rates, etc., but let's ignore them for now.
As an example, if T-bills are yielding 10%, $1 today will be $1.10 next year, $1.21 the second year, etc. Therefore, if you will receive $121 dollars two years from now, the PV in those dollars is $100.
The advantage of PV is that ALL INVESTMENTS CAN BE REDUCED TO THE SAME BASIS through the use of PV.
Now, back to disability. How much is your future income stream worth now? By the argument above, it is:
PV = (Salary in year 1)/(1+i) + (Salary in year 2)/(1+i)^2 + ...
+ (Salary in year N)/(1+i)^N (Eq. 1)
For most of us after our first few years of working, our salary grows at the inflation rate, which is also closely approximated by the T-bill rate (accept this assertion now, see below). Thus
(Salary in year N) = (Salary in year 0) * (1+i)^N (Eq. 2)
This makes the PV of your income stream very simple. It is just N times your current salary, where N is the number of working years you have left.
If your current salary is $30,000 / year, and you have 35 years left to work, the PV of your income stream is 35 * $30,000 = $1,050,000. In other words, your present value is a million dollars, and that is your fair market value now. (If slavery existed, that is what a reasonable person would pay for your services, minus your living expenses.)
So, for most of us, our future income stream IS BY FAR OUR BIGGEST ASSET. Doesn't it make sense to insure against losing that million dollars, your biggest asset? It is worth much more than your house or car, both of which you probably have insurance on.
Note that it is again extremely important to get inflation protection in your disability insurance, unless you are very close to retirement age. (See discussion under retirement above.) If you don't, you are only insuring
PV = (Salary in year 1)/(1+i) + (Salary in year 2)/(1+i)^2 + ...
+ (Salary in year N)/(1+i)^N
= (Salary in year 1) * ( 1/(1+i) + 1/(1+i)^2 + ... +
= (Salary in year 1) * (1 - 1/(1+i)^N) / i (Eq. 3)
For the example given above with N=30 and Salary of $30,000 / year, the PV now is only $30,000 * 16.37, if i = 0.05, or only $491,000 instead of $1,050,000.
Typical disability policies ensure 60% of your salary, making it even more important to get inflation protection. Unfortunately, the CIT/JPL disability insurance plan does NOT provide inflation protection.
Ca. SDI covers up to salaries of $22,000 / year, and gives benefits of TBS for up to one year.
Disability insurance gets a lot cheaper by having a longer waiting period before it kicks in. Your sick leave and cash cushion should enable you to last 3-6 months easily, so don't buy a policy with a shorter waiting period than that. Get the longest you can get by with.
Note that a 35 year old person is 3 times more likely to be seriously disabled for at least 3 months than to die. A 50 year old person is 4 times more likely to be disabled than to die.
You almost certainly need life insurance if you have children, a spouse who does not and cannot or will not work, or if you own a house with a spouse who would lose the house without your salary. In these cases, you should buy only term insurance and only for the amount you need. Make sure to adjust that amount downward every few years, as the PV of your future needs declines.
You calculate how much insurance you need in the same PV way. Estimate how much money is needed at what times. Convert every amount into a PV. Add up all those PVs. SUBTRACT the PV of your current net worth that could be liquidated and the PV of other income your survivors will receive, such as Social Security, welfare, whatever. If the balance is positive, you need that much life insurance. Again, perform the calculation every few years and decrease your insurance regularly.
Example: Charge an item costing $1000, and let the entire amount revolve, paying 18% interest per year. Your payments will be $180 / year. If you had instead put the $180 / year into a saving account paying 5% per year after taxes, you would build up $1000 after 4 years. Therefore, by charging this item, at the end of year 4, you would have enjoyed a higher standard of living (your $1000 item) for 4 years, but would now have a $1000 debt. If you had waited 4 years to buy the item, you could have used your $180 / year savings to accumulate the $1000, purchase the item, and have no debt. So you have paid an extra $1000 for the privilege of enjoying $1000 for 4 years.
More precisely, let's calculate the PV, assuming that the purchase has no lasting monetary value (in other words, the purchase is not an investment which will appreciate or maintain its value), and for completeness, I'll include inflation.
Option 1. Forego the $1000 purchase for 4 years and put the $180/year money in a savings account. At the end of 4 years, purchase the $1000 item, which will then cost $1000 * (1+i)^4.
PV = $180 * (1/(1+i) + 1/(1+i)^2 + 1/(1+i)^3 + 1/(1+i)^4)
- $1000 = $638 - $1000 = - $362, if i = .05 (Eq. 4)
Option 2. Purchase the $1000 item now, pay $180 / year interest, pay off loan at end of year 4.
PV = - $180 * (1/(1+i) + 1/(1+i)^2 + 1/(1+i)^3 + 1/(1+i)^4)
- $1000 / (1+i)^4 = - $638 - $823 = - $1461, if i = .05
So buying that $1000 item now and enjoying it four years earlier costs you $1099 in current dollars! So in effect, every item you buy on credit and allow to revolve for 4 years COSTS YOU DOUBLE.
Is it worth it?
Keep this money in cash equivalents, such as the JPL/CIT Credit Union, Certificate of Deposits (CDs) at banks or savings and loans, a money market fund, or short term Treasury notes or corporate bonds, either individually or through a mutual fund.
1. Any gains made from appreciation are tax-deferred.
2. Up to $125,000 of the gains are free from taxation once you are over 55, including gains deferred from previous houses.
3. Because your interest costs are deductible, you can afford a payment of 1/(1-b) times higher than what you can afford to pay in rent. b represents your combined federal and state tax bracket, in the following way:
b = bfed + (1-bfed) * bstate , (Eq. 6)
since state income tax is deductible on your federal return. For example, if you are in the 28% federal bracket and 9.2% state bracket, your net tax bracket is 34.6%, and you can afford a house payment that is 1.53 times higher than the rent payment you can afford.
4. You would have to pay rent anyway, so you get a home for very little additional cost and much additional benefit. In effect, you convert your rent payment and some of your taxes into savings and security.
5. You fix your monthly payments for 30 years (or the life of your mortgage) and live payment free after that. (Even if you get a variable rate loan, the payments will have a fixed cap, and you will probably end up refinancing with a fixed rate loan whenever interest rates drop.)
6. No one can evict you for any reason if you own your own home.
7. You can do what you want (within limits) to your own home without getting anyone else's approval.
Of course, you become responsible for calling the plumber, putting on a new roof periodically, painting periodically, landscape maintenance, etc., but the benefits far outweigh the drawbacks.
Advice: Get as big a mortgage as you can. Reasons:
- You maximize your flexibility in saving your other cash for other needs, such as emergencies, investing, divorce, etc., without having to apply for a second mortgage at higher rates.
- You can invest the money and get a return typically higher than what you are paying in interest.
- You maximize your interest deduction.
Note that once you buy a house, for a long time it will dominate your net worth, so to properly diversify your net worth, it does not make sense to invest in other real estate. Also, there are better investments around anyway, unless you love to fix up houses for resale using your own labor.