What Is Homeowners Insurance and How Does It Work?

What Is Homeowners Insurance?

Homeowners insurance is a form of property insurance that covers losses and damages to your residence, along with furnishings and other assets in the home. Homeowners insurance also provides liability coverage against accidents in the home or on the property.

How Homeowners Insurance Works

A homeowners insurance policy usually covers four kinds of incidents on the insured property: interior damage, exterior damage, loss or damage of personal assets/belongings, and injury that occurs while on the property. When a claim is made on any of these incidents, the homeowner will typically be required to pay a deductible.

Policy providers offer riders that increase coverage for specific events, cover high-value property, and can reduce deductible amounts. These adders cost an additional premium.

The insurance provider will usually depreciate the value of the covered property based on its age, use, condition, and useful life. The insurer deducts the depreciation value from the replacement cost to arrive at the actual cash value (ACV) that they will return to the insured.

For example, say a claim is made to an insurer for interior water damage that has occurred in a home. A claims adjuster estimates the cost to bring the property back to livable conditions to be $10,000. If the claim is approved, the homeowner is informed of the amount of their deductible, say $4,000, according to the policy agreement.

In this case, the insurance company will issue a payment for the excess cost of $6,000. The higher the deductible on an insurance contract, the lower the monthly or annual premium on a homeowners insurance policy.

Liability limit

Every homeowner's insurance policy has a liability limit that determines the amount of coverage you have. The standard limits are usually $100,000, but you can often choose a higher limit. If a claim is made, the liability limit stipulates the percentage of the coverage amount that would go toward replacing or repairing damage to the property structures, personal belongings, and costs to live somewhere else while the property is worked on.

Acts of war or acts of God such as earthquakes or floods are typically excluded from standard homeowners insurance policies. If you live in an area prone to these natural disasters, you may need special coverage to insure your property against floods or earthquakes.

Homeowners Insurance and Mortgages

When you apply for a mortgage, you're usually required to provide proof of insurance on the property before the banks will loan you funds. The property insurance can be acquired separately or by the lending bank.

If you want to get your own insurance policy, you can compare multiple offers and pick the plan that works best for your needs. If you don't have your property covered from loss or damages, the bank may get one for you at an extra cost.

Payments made toward a homeowners insurance policy are usually included in the monthly payments of your mortgage. The lending bank that receives the payment allocates the portion for insurance coverage to an escrow account. Once the insurance bill comes due, the amount owed is settled from this escrow account.

Homeowners Insurance vs. Home Warranty

Homeowners insurance is different from a home warranty. A home warranty is a contract that provides for repairs or replacements of home systems and appliances such as ovens, water heaters, washers/dryers, and pools.

These contracts usually expire after a certain period (usually 12 months) and are not mandatory for a homeowner to buy to qualify for a mortgage. A home warranty covers issues and problems that result from poor maintenance or inevitable wear-and-tear on items—situations in which homeowners insurance doesn't apply.

Homeowners Insurance vs. Mortgage Insurance

A homeowners insurance policy also differs from mortgage insurance. Mortgage insurance is typically required by the bank or mortgage company for homebuyers making a down payment of less than 20% of the cost of the property.

The Federal Home Administration also requires it of those taking out an FHA loan. It's an extra fee that can be figured into the regular mortgage payments or may be a lump sum charged when the mortgage is issued.

Some homeowner policies include a mortgagee clause. The clause covers and pays the lender in case your home is lost or irreparably damaged during the time you have a mortgage on it.

Mortgage insurance covers the lender for taking on the extra risk of a home buyer who doesn't meet the usual mortgage requirements. If the buyer should default on payments, the mortgage insurance would compensate the lender. Basically, while both deal with residences, homeowners insurance protects the homeowner while mortgage insurance protects the mortgage lender.

The Bottom Line

Homeowners insurance covers a variety of damages to your home and other assets at your residence. While most policies provide several basic coverages, the types of losses that are insured can vary widely across the industry. To find the most affordable home insurance for your situation, consider getting home insurance quotes from several insurance providers.