When you take out a homeowners insurance policy -- also known as a hazard insurance policy -- when you buy a home, you may think that the policy is only designed to protect you, the policy holder. In the unfortunate event of a fire or significant property damage caused by another event, homeowners insurance helps you pay to repair or rebuild your property.
What you may not know is that your insurance policy also protects your lender if you have a mortgage on your home. Homeowners insurance policies contain a “loss payee” clause that basically states that if you decide to walk away from your home and you stop paying your mortgage due to significant property damage, the lender recovers its outstanding loan balance from the insurance proceeds before any other insurance claims are paid.
In short, if you do not pay your mortgage after your property is damaged or destroyed, your insurance policy pays your lender before you. So the policy protects the mortgage lender as much as if not more than the homeowner.
This explains why lenders require that you have homeowners insurance to get approved for a mortgage and as long as your loan is outstanding. If you lapse on your coverage, such as if you miss a premium payment, you are technically in default on your mortgage.
If you do not correct the issue and bring your policy current, the lender is allowed to purchase a policy for you and send you the bill. The policy your lender buys on your behalf may not offer the same level of coverage or it may cost more.
Given that mortgage lenders require you to have homeowners insurance -- to safeguard their interests as much as yours -- you may be wondering how much coverage you need to satisfy this requirement? Simply put, lenders only require that your policy covers their mortgage amount.
For example, if you buy a home that appraises for $500,000 and finance the purchase with a $300,000 mortgage, from the lender’s perspective, your homeowners insurance policy only needs to provide $300,000 in coverage. You can elect to purchase a policy that covers the full replacement value of the property -- $500,000 in this example -- but purchasing additional insurance is at the discretion of the homeowner and cannot be required by your lender.
The more coverage and lower your deductible, the higher your premium which is an important consideration for homeowners. If you have limited financial resources then a policy with a lower coverage level may make more sense.
Despite the higher cost, in most cases homeowners choose an insurance policy that covers the full value of their property, which also satisfies the lender’s requirement. But to reiterate, your policy is only required to cover your mortgage amount, at least from the lender’s standpoint.
We recommend that you work with your insurance company to select a policy that both provides the amount of coverage you want and fits within your budget. Do not get pressured by your lender into choosing a policy that you do not need or want.
If your lender is requiring you to purchase additional, unnecessary homeowners insurance you should consider changing lenders. We advise you to shop multiple lenders in the table below to confirm their insurance requirements and to find the best mortgage terms.
“What is homeowner's insurance? Why is homeowner's insurance required?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.