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What does homeowners insurance cover, and why does your lender require it?

Gina PogolThe Mortgage Reports Contributor

In this article:

If you finance your home with a mortgage, you’ll have to purchase homeowners insurance. That’s for your lender’s protection and yours. What does homeowners insurance cover?

  1. Homeowners insurance reimburses losses from damage by covered causes, and living expenses if you have to temporarily move
  2. It also includes liability protection for damage or injuries caused by you or your household members
  3. Homeowner policies also cover your personal possessons

Homeowners insurance should not be confused with flood insurance, mortgage insurance or mortgage protection life insurance. Also, a standard policy will not pay for damage caused by an earthquake or routine wear and tear.

Verify your new rate (Sep 24th, 2018)

Why mortgage lenders require homeowners insurance

Mortgage lenders require homeowners to carry homeowners insurance. There are a number of reasons for this, but the most important one is that your lender wants you to be able and willing to repay your mortgage after catastrophic damage.

Related: Do homeowners need mortgage life insurance?

After all, many people would find it difficult to continue paying a mortgage on a home in which they cannot live. Without the home, the mortgage has little value. The threat of foreclosure is pretty hollow when there is no livable dwelling to repossess and sell.

So, what does homeowners insurance cover? You and your mortgage lender.

Forgetting to buy homeowners insurance will derail your closing!

It is crucial that you shop for your homeowners insurance policy once you open escrow on a home purchase. And your policy must be acceptable to your lender, so you should supply your policy declarations page, or “dec sheet,” as soon as possible.

Related: Preparing for your real estate closing

Lenders establish a minimum amount of insurance coverage that you must obtain before they will fund your mortgage. For instance, Fannie Mae requires the lesser of

  • Coverage equal to 100 percent of the insurable value of the improvements (usually, this excludes the land); or
  • Insurance sufficient to repay the unpaid principal balance of the mortgage as long as that amount equals at least 80 percent of the value of the improvements

Fannie Mae will not accept a policy that excludes damage caused by “windstorm, hurricane, hail damages, or any other perils that normally are included under an extended coverage endorsement.”

Suppose that you buy a $300,000 property, and the home’s replacement cost (you can find this on the appraisal, but the insurer will come up with its own number) is $200,000. If your loan amount is $240,000, you calculate your required coverage like this:

  • $200,000 equals the value of the improvements
  • $240,000 is the unpaid principal balance

Your insurance coverage requirement is the lower amount, $200,000.

Homeowners insurance: 4 components

A typical policy covers four major areas, and you can add “riders” to increase protection in any of them.

Dwelling

Covers damage to the home and attached structures. You’ll usually also get coverage for detached structures lke gazebos or sheds for up to 10 percent of the insurance amount on the house. Ordinary covered events include fire, hurricane, hail, and lightning.

Mortgage lenders seldom require borrowers to purchase replacement value insurance, but it’s smart to consider it. What if a wildfire destroys your $200,000 home, and it costs $250,000 at current prices to rebuild it?

If you can’t easily cover the difference, it makes sense to purchase replacement value insurance even though it costs more

ALE

Additional living expenses (ALE): Covers living expenses while your home is unlivable while yours is being repaired or rebuilt. This coverage may be limited to a certain dollar amount or number of days. If you were renting out part of your house, ALE also reimburses you for the rent that you would have collected if your home had not been destroyed.

Related: Buying a home in an area hit by a natural disaster

Personal liability

Your homeowners insurance provides financial protection against lawsuits from damage or injuries that occurred on your property. This includes no-fault medical payments for others (not you or your family or pets) injured in your home. They can simply submit medical bills to your insurance company.

It also pays for damage caused by your pets or children. If they destroy your neighbor’s designer window playing ball, you’re covered. If they destroy your window, though, tough luck. Your liability policy also pays to defend you in court and any damages awarded up to the limit stated in your policy documents.

Liability limits generally start at about $100,000 but you can buy more. If you have significant assets, or are a well-known public person, you may want even more coverage. An umbrella policy, aka excess liability policy, kicks in once your homeowners insurance liability benefit is exhausted.

Personal possessions

Your policy covers destroyed or stolen personal property, usually 50 to 70 percent of the amount of your dwelling coverage. Personal property off-premises is also covered, but there may be limits (typically to 10 percent of your personal possession coverage).

You also usually get $500 coverage for unauthorized use of your credit cards, and about $500 per landscaping item like trees and shrubs (if destroyed or stolen, not if you just have a black thumb and kill them through neglect).

Limits also apply to expensive luxuries, so you may need a special personal property endorsement or “floater” to insure the item for its officially appraised value.

How much does homeowners insurance cost?

According to Insurance.com, the national average premium for a $200,000 home with $100,000 in liability coverage is $1,244. Like auto insurance, the cost of homeowners insurance depends on your policy traits.

Your local crime rates affect what you pay for hazard insurance, for example, because with more crime in the area, your potential for loss is greater. Similarly, the closer your home is to a police station; a fire station; and, water supply, the lower your insurance premium can be expected to be.

Related: Guide to becoming a landlord in 2018

In addition, if the previous homeowner filed homeowners insurance claims within the last five years, your premiums could be higher. Insurers have access to the Comprehensive Loss Underwriting Exchange (CLUE) system, and use it to determine if your home is especially likely to generate new claims.

Beyond the amount of coverage you seek, and the policies you choose to carry, there are five key factors which can affect your final policy costs.

  • Home age : In general, newer homes are less expensive to insure than older ones
  • Construction type : Premiums are typically lower for brick homes as compared to frame homes
  • Proximity to services : The closer your home is to a fire hydrant; and the local fire station, the lower your policy costs, in general.
  • Coverage amount : The greater your coverage of personal items, the higher your premium costs
  • Deductible : Larger deductibles lower annual premium costs

Deductible choices typically range from $250 to $1,000, although some insurers offer options on either side of that scale. Choose an appropriate deductible for your financial situation.

Also, for added savings, note that some insurers offer multi-policy discounts to their customers. This means that if you insure your automobile and home with the same insurer, you may be eligible receive a discount on both policies.

Verify your new rate (Sep 24th, 2018)

How do you pay your homeowners insurance?

When you buy a home, your lender requires you to pay your first year of insurance at closing. After that, there are two ways to pay your premiums.

You can pay the insurance yourself when the premium comes due f your lender allows this. If your down payment (or home equity, if refinancing) is more than 20 percent, you’re more likely to get this privilege.

You may have to pay an extra fee, however, because allowing homeowners to pay their own property taxes and homeowners insurance is riskier to the lender.

Related: How to avoid having an impound account with your mortgage

Your other option is an impound or escrow account. Your lender adds 1/12th of your annual premium (and your annual property taxes) to your monthly mortgage payment, and when your insurance comes due, the lender pays it for you. Each year, your lender or loan servicer evaluates your impound account and may adjust your monthly payment or refund excess payments.

When lenders talk about your PITI payment, that’s what they’re referring to: principal, interest, taxes and insurance.

Verify your new rate (Sep 24th, 2018)