Before finalizing a home purchase, the vast majority of buyers arrange for homeowners' insurance on their new property. Such coverage is important for two reasons: First, because if the homebuyers are taking out a mortgage loan, their lenders will require them to purchase at least a minimal level of "hazard insurance." Second, it serves to protect the homebuyers' personal interests; not only with regard to damage with the house, but because the standard policy also includes personal liability insurance and additional hazard coverage (more than the lender requires).
We'll get into the details here, including:
A standard, comprehensive homeowners' insurance policy includes:
The list of damage and disasters commonly covered by hazard insurance is surprisingly long: unintentional physical damage to your property and its contents caused by fire and smoke, wind, hail, lightning, explosions, volcanoes, riots and vandalism, theft, water damage, and similar events. In addition to covering the house itself, the hazard coverage will typically protect furnishings and other personal items, as well as any other structures on the property, such as a pool or separate garage (unless you use these for nonresidential purposes, such as for a home business).
Watch out for what's listed in the "exclusions" section of your policy, however. Most policies' hazard coverage doesn't cover business equipment, damage caused by natural disasters, or loss of art or jewelry over a certain amount. It's also typical for policies to exclude damage caused by mudslides, police activity, power outages, sewer backups, dry rot, and vermin. You will want to purchase additional hazard coverage if your house is in a high-risk area for fire, floods, earthquakes, or other natural disasters; or if you have expensive art, jewelry, or business equipment at home. The key is to buy added coverage for hazards that can cause huge damage (like sewer backups) or that are big risks in the area where you live, like earthquakes in parts of California, hurricanes along the Gulf Coast and Eastern Seaboard, or sinkholes in parts of Florida.
The liability insurance portion of your policy compensates for two things:
Standard homeowners' policies traditionally provide around $100,000 in liability coverage. You can easily imagine how someone's medical bills could top that amount, however. It's true that, unlike hazard insurance, personal liability coverage isn't required by mortgage lenders. Nevertheless, rather than putting your house at risk of being sold to pay a court judgment or someone's medical bills, make sure your liability coverage is at a realistic level. Experts put this between $300,000 and $1 million. An alternative way to calculate this is to set it at the level of your assets. In other words, if a major court judgment forced you to sell your home, boat, art collection and/or vacation home, how much would you stand to lose?
Let's take the most unlikely (but scary) scenario: A fire or other hazard destroys your house or makes it unlivable. You might expect your insurance company to pay for it to be rebuilt, or restored to just what it was before, but what will actually happen depends on the terms of your policy.
Again, this isn't a blank check situation. In the worst case, if you are underinsured, you could find that you can't afford to rebuild and will have to sell the damaged property.
The norm: replacement cost coverage. If your house is basically destroyed, the amount you receive to rebuild under a standard policy with "replacement cost" coverage will be a set dollar figure, which you'll see in the policy. That figure is calculated in advance, using information you provide to the insurance company about the house's size, location, number and type of rooms, building materials, amenities, historical features, and more. That's often information that you report to your insurance agent or company when you first purchase the policy.
However, when disaster strikes, this figure could turn out to be way off the mark, particularly if you underreported your house's features, building costs have gone up, a widespread natural disaster increases demand for home builders and contractors, you have remodeled and not updated your insurance, or your house has historical features that will be hard to recreate. The lesson here is to make your insurance carrier aware of your home's many fine features, rather than trying to reduce your premium by hiding them.
Another issue of concern is that, by the time you need the insurance coverage, municipal building codes might have changed. For instance, your city or locality might require better and more extensive electrical wiring, thicker walls with higher-quality insulation, more fire protective features, and so on. The result might be that restoring heavily damaged portions of your home can no longer be legally done. Such a situation will require you to make major changes to the home's design and plan, rather than just recreating what was there before. To deal with this possibility, many experts recommend separately buying building-code upgrade coverage, so that the insurance company automatically pays for the increased costs caused by such building-code changes.
To be avoided: actual cash value coverage. If an insurance company offers you a policy that pays the "actual cash value" of your house, start looking elsewhere for coverage. Cash value policies are sometimes pushed on people with older houses or ones with an inadequate water supply (a fire danger). With actual cash value coverage, you'd get the house's replacement cost minus any depreciation or wear and tear that it has suffered since being built—for example, the insurance carrier might deduct for a roof that needed to be replaced—which means you are almost guaranteed not to have enough with which to rebuild the place.
The ideal: guaranteed replacement coverage. If you look very hard (and pay much more), you might just find a policy that guarantees payment of 100% of your repair or rebuilding costs, without limits. This rare and wonderful creature is called a "guaranteed replacement cost" policy. If your house has historical features that are hard to reproduce, finding such a policy will be especially difficult, however.
In addition to checking your homeowners' policy for how much you'll get to rebuild your home with after major destruction, check the fine print for these related items:
A deductible is the amount you must pay after a loss before your insurance company steps in. Most homeowners agree to a $500 deductible (for the hazard portion; liability insurance doesn't normally carry a deductible).
However, raising your deductible to a higher amount can be a great financial move. It not only allows you to significantly reduce your premium costs, but also prevents you from being too quick to call your insurer for coverage. The more claims you make, the more likely the insurer is to raise your premiums or cancel your policy.
Of course, you'll want to make sure you set aside the deductible amount in savings, perhaps within an emergency fund. That way, you won't find yourself trapped, unable to spend enough to trigger the insurance coverage. And you'll also need to check in with your mortgage lender, which might limit the allowable amount of your deductible.
Finding good homeowners' insurance coverage can be surprisingly difficult, especially in states where high payouts for mold, wildfires, and other disasters have made the insurance industry skittish.
If either you or the seller of the property have made claims for water damage (the usual precursor to mold) in the past, you might actually find that you can't purchase a policy at all; or at least not a reasonably priced one. The same thing goes if you've filed many insurance claims, despite the fact that there were made on different properties. You might not be able to find a company willing to sell you insurance at all.
You can protect yourself against the possibility of not getting homeowners' insurance for a house you're buying by negotiating with your sellers to make your obtaining insurance a contingency or condition of finalizing the sale.
Guard your policy well once you've got it. Don't file claims unless you have to.
If you file more than two or three claims, your rates will likely rise and your policy might be canceled. You are best advised to get a policy with a high deductible, so that you've got no reason to file lower-cost claims that will raise your premiums or lead to future cancellation of your policy.
Your lender might, however, insist you not go higher than a certain deductible amount, such as $1,500. The lender wants to ensure that you won't get into a bind if you're unable to afford the deductible and therefore unable to make the repairs needed to trigger your insurance coverage, thus devaluing the lender's collateral (your house).
For detailed information on homeowners' insurance and other aspects of buying and owning a home, see Nolo's Essential Guide to Buying Your First Home, by Ilona Bray, Ann O'Connell, and Marcia Stewart (Nolo). And if you get into a dispute with your insurance company about what's actually covered under your policy, definitely consult an attorney.
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