What is Homeowners Insurance and How Does It Work?

Like other types of property and casualty insurance like car insurance, the insurance company will charge you a set amount premium based upon the needs of your property. You can pay this premium in a lump sum, but most homeowners pay it on a monthly basis.

In exchange for your premium, your insurance company agrees to cover the structure of your home, other structures on your property (sheds, fences), your personal property in your home, and liability coverage to protect you if an incident occurs on your property.

If you need to use your policy, you will have to pay your deductible before your insurance kicks in. Some insurance companies will charge a flat amount of money for your deductible, while others will use a percentage based upon the coverage on your policy.

For example, say that that fire broke out and ruined part of your home. After a claims adjuster from the insurance company reviews the damage, they estimate it will cost $50,000 for repairs. If you had a flat deductible of $4,000 you would be responsible to pay $4,000 of the repairs, and your policy would cover the remaining $46,000.

It is also important to understand that most home insurance policies use several methods to evaluate how much of a payment you are entitled to based upon the type of coverage you are using under your policy. The amount of money you can receive will depend on if the coverage uses an actual cash value method or a replacement cost method.

Actual cash value coverage - Actual cash value coverage covers the cost to replace or repair your damaged property minus depreciation. This method is typically used to cover your personal property within your home, but not the home itself.

For example, let's say that there was a fire in your home that destroyed some of your personal property including your TV. Let's assume that you bought this TV a couple of years back for $1,000. Let's also assume that the TV went down in value (depreciated) by $100 per year.

Your insurance company would look at the original value of the TV, and subtract the depreciation of the TV to find the appropriate pay out. In this case it would be $800 ($1,000 original cost minus $200 of depreciation over 2 years). Since your TV has gone down in value, your insurance company is not required to buy you a brand new one. Instead, they will restore you to your previous position.

Replacement cost coverage - Your home and any other structures on your property typically use a replacement cost coverage method. Essentially, your home insurance company will pay to repair damage to your home with materials of "like kind and quality.

For example, if the exterior of your home was made of vinyl siding and incurred damage from wind, your policy would cover the cost to replace the old vinyl siding with new vinyl siding. It is important to note that replacement cost coverage will not pay out more than your policy limits.

Your homeowners policy will typically cover anything that is not specifically excluded in your policy for the dwelling and other structures coverage. Your personal property will only be covered under specific "perils" for your specific policy. Let's take a closer look at what is covered below.

Dwelling coverage covers the structure of your home itself. This would include your walls, roof, floors, and windows. It also covers structures attached to the home itself such as your garage, deck, and porch. For most policies, any incident that causes damages to one of these structures is covered unless your policy specifically excludes in.

Common claims often include incidents related to wind, fire, hail, lighting, and freezing that causes damage to your dwelling. If your home was damaged from one of these events, you would be able to make a claim and your policy would cover the damage minus your deductible.

It is important to note that your dwelling coverage is based upon the replacement cost of your home and not your home's market value. For example, your home might be worth $600,000, but it might only cost $500,000 to rebuild or replace your home.  

As the name implies, this covers other structures that you have on your property that are not attached to your home. This could include sheds, fences, and detached garage. Like dwelling coverage, any incident that causes damage to these "other structures" on your property is typically covered unless specifically excluded by your policy.  

Common perils that are covered include fire, wind, hail, now and others. So, if your fence were to get destroyed by high-speed winds, you would be able to make a claim for the cost of repairs after paying your deductible.

Personal property coverage covers all of your personal belongings within your home. Think of items such as clothing, electronics, furniture, and more. If you were to remove the roof of your house and tip the house upside down, whatever fell out would be considered personal property.  

Unlike dwelling and other structures coverage in which anything not specifically excluded is covered, personal property only offers coverage under specific circumstances listed in your policy. These are often referred to as "perils." They tend to include the following.

- Fire or lightning

- Smoke

- Windstorms and hail

- Explosions

- Theft

- Vandalism

- Weight of ice, snow, sleet

- Sudden damage from a power surge

- Volcanic eruptions

- Falling objects

- Water overflow or discharge from household systems

- Freezing of household systems

- Sudden tearing, cracking or bulging of a hot water, steam, air conditioning or fire protective system

- Riots

- Damage from aircraft or vehicles

Loss of use coverage protects you if damage to your home makes your home uninhabitable. The coverage will pay for you to live some place else as your home is being repaired. Your insurance company will pay for a hotel or cover rent for another home near buy that is similar to yours.

For example, let's say that your house incurred severe fire damage and needed to be repaired. As you wait for contractors to repair the damage, your insurance company pays for you to rent another home near yours. Some insurance companies offer a set amount for loss of use coverage, while others offer unlimited coverage.

Most homeowners policies offer personal liability coverage that can protect you if you or a member of your household is responsible for causing injury to anther person or damage to their property. You will not be covered if you cause injury or damage on purpose, or with criminal intent.

For example, let's say that you have a guest walking through your home and an object falls onto them causing injury. Your liability coverage would cover the costs of your guests' medical bills, as well as the cost of a legal defense if necessary up to the limits of your policy.

Personal liability coverage can also cover incidents that do not happen in your own home. For example, let's say that your child accidently threw a baseball through your neighbors window causing significant damage. Your personal liability coverage would be able to cover the cost of repairing the damage.  

It should be noted that personal liability coverage does not protect you if you caused injury or damage to another person due to a car accident. In this incident, the liability coverage of your car insurance would cover you. Most homeowners policies offer at least $100,000 in coverage but you can up that amount or buy a personal umbrella policy for more liability coverage if necessary.

Medical payments coverage is like personal liability coverage in that it will pay for the medical bills of others who are accidentally hurt on your property. Unlike personal liability coverage, it does not matter who was at fault.  

For example, let's say that a guest came over to your home, tripped on your stairs and injured themselves. Your medical payments coverage would be able to help cover the cost of their medical bills. Typical amounts of coverage range from $1,000 to $5,000.

If you do not believe this is enough coverage, most insurance companies will allow you to raise the amount. Keep in mind that medical payments coverage does not protect members of your own household. It only protects individuals who are not members of your household.

Although homeowners insurance will cover your property in most scenarios, it is important to know what your policy will not cover. First, your policy will not cover your home if you intentionally damage it. The following are also typically excluded from coverage under most policies.

- Flooding from external sources like heavy rain or storm surges

- Drain and sewer backups

- Earthquakes, landslides, and sinkholes

- Infestations by birds, vermin, fungus and mold

- Wear and tear or neglect

- Nuclear hazard

- Government action, including war

- Power failure

If you are concerned that your property could be damaged by one of these excluded incidents, you might be able to purchase additional coverage or add endorsements onto your policy. For example, flood and earthquake insurance can be purchased in addition to homeowners insurance.

In addition to the six main coverages offered by most homeowners policies, you can also bolster your coverage by adding optional coverages. These coverages are referred to as endorsements. The following are common endorsements.

Sewer backup/water backup coverage - This coverage can help pay for damage due to backed up sewer lines, drains or sump pumps. Coverage amounts typically range between $5,000 and $10,000.  

Service line coverage - This coverage can help pay for costs that are associated with underground utility lines should they need to be repaired. Items such as electrical cables, water pipes, natural gas pipes, cable lines and others are typically covered.

Ordinance or law coverage - This coverage can help pay additional costs associated with local building requirements after a covered loss. For example, let's say that your house burned down and it needed to be rebuilt. If your local ordinance requires your home to be rebuilt in a certain way, ordinance or law coverage can help pay for additional expenses associated with these costs.

Equiment breakdown coverage - This coverage covers household systems and appliances that breakdown because of a mechanical or electrical failure. Your home policy will cover these systems if the damage occurs from a covered peril such as fire, but not from mechanical or electrical failure.

Adding in this endorsement will add another layer of coverage to your household systems and appliances. Think of items such as your HVAC, refrigerator, washer and dryer and more.

Unlike car insurance, homeowners insurance is not legally required by state or federal law. However, most individuals will have to finance the purchase of a home. It is always going to be a requirement by the lender for you to have a homeowners insurance policy since your lender has a financial stake in your property.

It is still a good idea to maintain coverage when you pay off your mortgage or if you paid cash for the house when you bought it. If your home were to burn down and you did not maintain your homeowners insurance, you would be on the hook for the cost to rebuild your home. This can ruin your finances, so it is always a good idea to make sure you maintain proper coverage for your home for as long as you live in it.

The amount that you need will vary based upon the individual needs of your home. With that being said, it is a good idea to be overinsured instead of underinsured should you need to use your policy. You should think through each of these coverages to get an idea of how much coverage you need.

1) Dwelling coverage - Dwelling coverage is the meat of your homeowners policy. At the very least, you need to have substantial coverage to protect the home itself. The amount of dwelling coverage you need is based upon the replacement cost of your property.

When you shop for homeowners quotes, insurance companies will provide an estimate of your replacement cost based upon the age, location, and materials used in your home. Once you get an estimate from a company, it is a good idea to do your own research on replacement costs in your area.

For example, let's say that your home is 2,500 square feet. If the estimated replacement costs in your area are $300 a square foot you would need $750,000 worth of coverage (2,500 sq ft x $300 sq ft). You can speak with local contractors or look online to try to find what the estimated replacement costs in your area are for your home.

2) Other structures coverage - Most homeowners policies will take 10% of your dwelling coverage and apply it to other structures coverage. For example, lets say that your dwelling coverage was set at $500,000. Your other structures coverage would be set at $50,000.

If the other structure on your property is fairly basic, such as a storage shed, this may be enough. But if you have an additional structure on your property that is more complex, it is usually a good idea to increase the amount of other structures coverage.  

3) Personal property coverage - Most homeowners policies start by offering 50% of your dwelling coverage for your personal property. So, if your dwelling coverage were $500,000 you would have $250,000 worth of personal property coverage.

For some individuals this will be plenty of coverage, but for others it won't be. You should try to take an inventory of all the personal property within your home and ask if 50% of your dwelling coverage is enough.

4) Loss of use coverage - The default loss of use coverage for most homeowners policies is set at 20% of your dwelling coverage. You want to make sure you have sufficient loss of use coverage as you can incur additional living expenses from your loss of use.

For example, say that your home burned down, and your insurance company were to put you in a hotel. Assume that you normally spend around $800 per month on groceries. With the loss of your home however, you no longer have a kitchen.

You are forced to eat out and your grocery bill doubles to $1,600 per month. If your dwelling coverage on your home was $300,000 you would have a starting loss of use coverage of $60,000. If you have a large family or are worried that this coverage is insufficient, you can increase your loss of use coverage.

5) Liability coverage - Liability coverage typically starts at $100,000 for most policies and can go up to $500,000. In general, you want to have enough coverage to protect any assets you own that could be taken if you end up in a lawsuit.

For example, let's say that you had a stock portfolio that was worth $250,000. Instead of opting for the base coverage of $100,000 you could increase your coverage to $250,000. In addition to your homeowners policy, you could purchase a personal liability umbrella policy if necessary.  

6) Boost your coverage and add endorsements - If you checked the boxes above, you have a pretty solid homeowners policy. However, there might be gaps in your coverage that you want to close. You can do this by purchasing additional coverages or by adding endorsements.

Homeowners insurance does not cover natural disasters such as floods, hurricanes, and earthquakes. If you live in an area that is susceptible to these disasters, you can purchase separate policies to cover them. Often, you will be required to purchase them.

Additionally, you can boost your coverage by adding endorsements. You do not need to buy every endorsement offered, but it can be a good idea to get endorsements that cover common occurrences. These could include a sewer/water backup endorsement or a service line endorsement.

The average cost of homeowners insurance across the United States is about $1,800 per year. However, this number varies drastically depending upon your home, coverages, and location. These are some of the factors that impact what you will pay for coverage.

1) The location of your home - If you live in an area prone to natural disasters, you will pay more for coverage. Coverage tends to be more expensive in cities than suburban or rural areas. Insurers will also look to see how close your zip code is to fire stations and if your neighborhood has a high crime rate with frequent home break ins.  

2) The replacement cost of your home - As previously discussed, the replacement cost of your home is what it would cost to rebuild your home if it were destroyed. The more replacement cost you need, the more you will pay for coverage.

3) Your deductible - The higher your deductible, the lower your premium. This can be an option to save money on your policy, but it is important that you have substantial funds that you can access in case you need to use your policy and cover your deductible.

4) The condition of your roof - If your home's roof is fairly new and is made with good materials, it will do a better job of protecting your home which can often result in a lower premium. On the flipside, if your roof is 15 years or older and is in bad shape, you can pay more for coverage.

5) Your claims history - If you only file claims on occasion, your claims history will not impact the price you pay for coverage that much. But, if you have a history of frequent claims, your insurer will see that as a red flag and will charge you more for coverage. Frequent theft and water damage claims most commonly impact what you will pay.

6) The age of your home - The newer your home is the less you will pay for coverage. New homes have good roofs and home systems that will last for a long time. This means that new homes are less expensive for insurance companies to insure than older homes.

7) Your credit history - Insurance companies will run their version of a credit check to see how much of a risk you are. If you have a high credit score, you will pay less for coverage. If you have a low credit score you will pay more. Individuals with low credit scores are more likely to file claims which makes them more expensive to insure.

8) Home safety and protective features - If you take measures to better protect your home, some insurance companies will give you discounts. For example, you could add a home security system, burglar alarm, a deadbolt and more. The exact discounts offered vary by insurer so ask your agent what home safety discounts they offer and how you can obtain them.

1) Understand your coverage needs - Before you start shopping for a policy, it is a good idea to understand what coverage you need. Look at the six main types of coverages that most homeowners policies offer and try to estimate how much coverage you would need for each.

2) Start shopping for quotes - Once you have an idea of what coverage you need, you can start shopping for quotes. You can do this online through the insurer themselves or through a third party comparison site. It is a good idea to get at least 3 to 5 quotes to compare.

3) Work with a licensed agent for the best quotes - After you have a couple of quotes you like, it is a good idea to reach out to a licensed agent in your area that represents that company. You want to work with an agent that will help you scrutinize the coverages on your policy to make sure you have sufficient coverage. This can be a pain, but it is well worth taking the time to understand your policy.

4) Sign up for your policy - Once you have a policy that you are confident in, you can fill out any necessary paperwork required by the insurer and submit your first payment. This payment will bind the contract and immediately provide you coverage.

The bottom line is that home insurance provides coverage to repair or rebuild your home in a wide variety of events. Common events that are covered include wind, fire, smoke, theft, vandalism, and hail. Most homeowners policies have six primary coverages - dwelling, other structures, personal property, loss of use, liability and medical payments coverage.

It is important that you protect your home in each of these areas by obtaining sufficient coverage. Working with a licensed agent can help you navigate the complexities of a homeowners policy. The amount that you will pay for coverage will vary based upon the location, age, roof condition, coverages, and other factors of your home.