Loss payee clause is a provision in your homeowners insurance policy that all property owners should understand but hope never applies to them.
The loss payee clause is found on your homeowners insurance declaration and indicates that the outstanding mortgage balance will be repaid in the event of significant property loss or damage. The loss payee clause includes the exact name and address of the lender that holds the mortgage against the property to ensure that the lender is repaid from any insurance claim proceeds if the homeowner walks away from the home and mortgage as a result of significant property damage. It is important to highlight that the loss payee clause is almost never invoked, which is good news for homeowners.
If a property experiences significant damage from a fire or other event the homeowner may decide that they do not have sufficient insurance coverage to rebuild the property so they decide to abandon the property and stop paying the mortgage. In this case, the lender eventually assumes ownership of the property and can exercise the loss payee clause to file a homeowners insurance claim. Depending on the amount of the claim, the lender can use the proceeds to pay off all or part of the outstanding mortgage balance they are owed.
As this example demonstrates, the loss payee clause is only triggered in a worst case scenario but it illustrates several important features of your homeowners insurance policy. First, despite its name, your policy protects the lender in addition to you, the homeowner. You may have thought that you alone benefit from the insurance as the policy holder and premium payer, but that is not the case. In certain scenarios, the lender may benefit financially from your policy.
This dynamic also explains why lenders require you to have homeowners insurance (also called hazard insurance) to qualify for a mortgage. It is not necessarily because they are interested in your financial well-being in the event you suffer substantial property damage.
Lenders require borrowers to have homeowners insurance because it protects the value of the collateral (your home) used to secure the mortgage held by the lender. If a catastrophic event seriously damages or destroys your property and you do not have homeowners insurance, the value of lender’s collateral could plummet and the lender may not be able to recover the money they lent to you if you walk away from your mortgage.
If you have homeowners insurance, you could use the claim proceeds to repair or rebuild your home, restoring the value of the lender’s collateral. If you have homeowners insurance and still decide to walk away from the property, the lender can use the loss payee clause to collect the insurance funds and pay off all or part of the mortgage balance they are owed.
Understanding how lenders potentially benefit from your homeowners insurance policy also helps to explain why most mortgages contain a provision that requires you hold insurance for the duration of your loan.
Depending on your loan terms, if you fail to renew your homeowners insurance the lender may purchase a policy on your behalf and make you pay for it. In most cases, the policy obtained by the lender is more expensive than a policy you could purchase on your own. Additionally, if you fail to correct the issue and continue to not have homeowners insurance for an extended period of time, you could potentially default on your mortgage and lose your home.
This is why it is important for property owners to regularly review their homeowners insurance policy and stay current on their payments. Making sure that you have sufficient coverage to rebuild your home in the event it is destroyed ensures that your policy solely benefits you and not your lender. Because now that you know how the loss payee clause works, you know that you never want your lender to use it.