Q

How does homeowners insurance work?

A

Homeowners insurance is financial protection for your home, personal belongings, and other assets. It also covers legal and medical expenses if you’re held liable for an accident.

Homeowners insurance is a type of property insurance that helps cover the cost of damage or loss to the structure of your home as well as your personal belongings both inside and outside of the residence. It also provides personal liability coverage in the event you’re held liable for an accidental injury or property damage. 

Key takeaways

  • Homeowners insurance is a form of property insurance that protects your home, belongings, and liability in the event of damage to your house or an accident for which you’re liable

  • Every homeowners insurance coverage has a limit of liability, or the maximum amount you’re paid out for a claim

  • Homeowners insurance is not the same thing as a home warranty or mortgage insurance

  • Homeowners insurance is not required by law, but most mortgage lenders will require proof of insurance before extending you a home loan

How does homeowners insurance coverage work?

To keep your homeowners insurance active, you pay monthly or annual premiums, or insurance payments, to your insurer. Premiums are generally paid either directly from you to the insurance company, or as part of your mortgage payment via an escrow account

If your home is damaged in a bad storm, or a guest is injured on your property and files a lawsuit, you can file a claim with your insurer who will pay out for the incident if it's covered. Keep in mind that before paying you for a claim, your insurance company will require that you make a deductible payment. This is the out-of-pocket amount that you’re responsible for paying before the insurer will cover the remainder of a loss.  

Although they can be modified and tailored to suit your needs, a standard home insurance policy is made up of six components of coverage that provide financial protection in three important ways .

1. Damage to your home’s structure and personal belongings

If your home, its furnishings, or additional structures like your garage or shed are burglarized or damaged due to fire, bad weather or any of the 16 perils that are covered in a standard home insurance policy, your insurer can help pay for the loss. Those perils include:

  • Fire or lightning

  • Windstorms or hail

  • Explosions

  • Riots

  • Damage caused by an aircraft

  • Damage caused by a vehicle 

  • Power surges

  • Smoke

  • Vandalism

  • Theft

  • Falling objects

  • Weight of ice, snow, or sleet

  • Water damage caused by burst pipes or appliance overflow 

  • Frozen plumbing, heating, air conditioning or automatic fire sprinkler systems 

  • Volcanic eruptions

Damage due to flooding or earthquakes are not covered by a standard policy. You’ll need separate flood and earthquake insurance to cover your property against those catastrophes. 

Your property coverages come with a limit of liability , or the maximum amount the insurer will pay out for a loss. For the structure of your home, you’re covered up to your policy’s dwelling coverage limit. For additional structures on your property, you’re covered up to the other structures limit in your policy (usually 10% of your dwelling limit). If your belongings are stolen or damaged, you’re covered up to the personal property limit in your policy (typically 50–70% of your dwelling limit). 

2. Personal liability coverage for property damage and injury

Personal liability coverage protects you from expensive lawsuits or property damage for which you’re liable. This coverage protects liability occurrences both on and off of the insured premises, including:

  • Guest injury on your property (either accidental or due to negligence) 

  • Dog bites

  • Accidental damage to someone else’s property caused by you or a dependent of your household 

In the event the injured party files a lawsuit against you, your insurer will pay out for medical or legal expenses that come out of the incident. This coverage can also cover lost wages if the injured party is forced out of work for an extended period of time because of an injury. 

Personal liability coverage is typically offered in increments of $100,000, with a maximum limit of $500,000, although this will differ from company to company. If you have over $500,000 in combined assets, consider taking out a personal umbrella policy. Umbrella insurance provides additional liability protection in the event the coverage limits in your home or auto insurance policies are maxed out. 

3. Additional living expenses while your home is being repaired or rebuilt

In the event a hurricane, wildfire, or any covered disaster makes your home uninhabitable, loss of use coverage can help cover the cost of hotel stays, restaurant meals, and other additional living expenses while your house is being repaired or rebuilt. 

Additional living expenses coverage is typically set at 20% of your dwelling coverage limit, but most insurers let you select higher or lower limits.

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What are the different levels of homeowners insurance coverage?

The amount you’re paid out on a claim will depend on what level of homeowners insurance policy you have. There are several different types of homeowners insurance (HO-1 through HO-8), and each have their own built-in level of coverage. Generally speaking, the lowest level of coverage is cheaper, and the most comprehensive level of coverage is more pricey. 

There are three levels of coverage. 

1. Actual cash value 

This type of coverage pays out for the depreciated value of your home and personal belongings. In a standard HO-3 policy (the most common policy), personal property is usually covered at its actual cash value, and the structure of your home is covered at its replacement value. Most insurers give you the option to upgrade your personal property to replacement cost value for an additional cost. 

2. Replacement cost 

This level of coverage pays out the replacement value of your home and personal belongings without deducting for depreciation. In an HO-3 policy, the structure of your home is automatically covered at its replacement cost.

3. Extended (or guaranteed) replacement cost 

This level of coverage pays out an additional amount if the damage or loss exceeds the limit of liability in your policy. Most extended replacement cost add-ons can increase your policy coverage an additional 20% or 25%. That means if your home is insured for $250,000 and you have 20% extended replacement cost, you have an additional $50,000 in coverage in the event the damage to your home exceeds your dwelling coverage limit. 

Guaranteed replacement cost pays out whatever it costs to repair or rebuild your home to the way it was before it was damaged or destroyed, regardless of the cost. This is the most expensive level of homeowners insurance coverage, but well worth the additional premium if your home is susceptible to natural disasters. 

How does homeowners insurance work with a mortgage?

Prior to closing on a mortgage, your lender will typically require proof of homeowners insurance before extending you a loan. The bank or loan servicer may refer you to a specific local agency or insurance company to save you time, but be sure to compare policy options from at least three different insurance companies. To give yourself time to compare rates and coverage options, start shopping around for homeowners insurance at least three weeks ahead of your closing date

Your lender may set up an escrow account from which your property taxes, mortgage insurance, and homeowners insurance premiums are paid. If you have a mortgage but don’t pay into an escrow account, then you’ll have to pay for homeowners insurance directly. If you stop making insurance payments and your homeowners insurance lapses, the lending institution can purchase homeowners insurance on your behalf and charge you for it retroactively. 

Homeowners insurance vs. mortgage insurance

The two are sometimes mistaken for one another, but homeowners insurance and mortgage insurance are two entirely different types of financial protection. One way to look at it is homeowners insurance protects the borrower, while mortgage insurance protects the lender.

Mortgage insurance is typically required by lenders if you make a down payment of less than 20%. The lender obtains mortgage insurance on your behalf, and you either pay upfront at closing or incrementally as part of your monthly mortgage payment. Once you’ve reached 20% equity in the home, you’re eligible to have mortgage insurance canceled. 

Homeowners insurance vs. home warranty

Although homeowners insurance and home warranties both protect systems and appliances in your home, the two are vastly different in terms of how you’re covered. 

A home warranty, also referred to as home appliance insurance, is a contract that covers home systems and appliances that break down due to normal wear and tear. That means if your dishwasher or HVAC breaks down, a home warranty can help cover the cost of repairs or a replacement. Warranties are not a mortgage requirement.

Homeowners insurance covers your home and personal belongings — including systems and appliances in the home — if they’re damaged due to a covered peril like a fire or storm. A homeowners insurance policy won’t cover appliances that break down due to age or wear and tear. For additional protection for systems and appliances in your home, consider purchasing equipment breakdown coverage, a low-cost policy add-on offered by most insurers.

Frequently asked questions

How much does homeowners insurance cost?

The average annual homeowners insurance premium is $1,249, according to the National Association of Insurance Commissioners. The cost of your own policy could be more or less than that depending on your home’s size, age, and location.

What is the 80% rule in homeowners insurance?

Most lenders require that borrowers insure their home for at least 80% of its true replacement cost, or the amount it would cost to rebuild the home from the ground up. Replacement cost is not the same thing as the market value or purchase price of the home. The 80% rule also applies to how you’re paid out on a claim. If your house is insured for less than 80% and you file a dwelling coverage claim, your insurer will only pay out for the actual cash value, or depreciated value of the home.

Is it better to pay for homeowners insurance monthly or annually?

This likely depends on how financially flexible you are, but annually is usually the way to go if you can afford it. Just about every insurer offers a significantly reduced rate if you pay for homeowners insurance upfront. If you pay annually but decide to switch insurers or cancel your coverage in the middle of your policy term, the insurance company will reimburse you for any unused premiums.

How does homeowners insurance work for a condo?

If you own a condo, you’ll likely need to insure it with an HO-6 condo insurance policy, not the HO-3 or HO-5 homeowners insurance described in this article. The amount of condo insurance you need generally depends on your HOA’s master policy. Master policies usually include some amount of structural coverage for each individual unit. For that reason, condos generally don’t need as much dwelling coverage as single-family homes. Be sure to check what your master policy already covers before taking out your own condo policy.