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Understanding Homeowners Insurance

Mortgage lenders generally require it, and regardless, it's almost always a smart investment.
March 25, 2016
Homeowners Insurance, Insurance
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Your home is more than just a roof over your head. Chances are it’s your most valuable investment, and one you likely can’t afford to replace if disaster strikes. That’s why protecting yourself with homeowners insurance is so important.

In this article

Why you need homeowners insurance
What is and isn’t covered
What’s included in a homeowners policy
Choosing your coverage amount
The cost of homeowners insurance

Why you need homeowners insurance

Buying homeowners insurance isn’t required by law, but if you have a mortgage, your lender will likely require you to insure the home so it can protect its investment.

Even if you don’t have a mortgage, homeowners insurance is almost always a wise purchase that can safeguard your finances in a variety of ways.

Here are the main functions of home insurance:

  • Repair your home, yard and other structures: If your home were leveled by a severe storm or burned to the ground, could you afford to rebuild out of pocket? Homeowners insurance helps cover reconstruction to restore your place and property to its former glory.
  • Repair or replace personal belongings: Many policies cover your belongings not only inside the home, but also on the go. So whether your furniture is destroyed in a fire or your wedding ring goes missing from a hotel nightstand, your coverage can help repair or replace them.
  • Cover personal liability issues: If a guest trips and falls on your walkway and sues you, your dog bites a visitor, or you accidentally hurt someone away from home, homeowners insurance can help cover others’ injuries and your legal costs.

» MORE: Why your dog needs liability insurance

What homeowners insurance does and doesn’t cover

Two common types of homeowners policies are the HO-2 and HO-3. The HO-2, which is less comprehensive, is a “named-peril” policy, meaning it covers a specific list of problems.

The 16 perils covered with an HO-2 policy are:

1. Fire or lightning
2. Smoke
3. Theft
4. Vandalism
5. Windstorms and hail
6. Damage caused by vehicles
7. Damage from aircraft
8. Weight of ice, snow and sleet
9. Freezing of household systems
10. Riots
11. Explosions
12. Falling objects
13. Volcanic eruptions
14. Overflow or discharge of water
15. Damage from artificially generated electrical current
16. Sudden tearing, cracking or bulging of home

For protection that goes beyond these 16 problems, consider an HO-3 policy. HO-3 plans are “open-peril,” meaning they cover all risks except those your insurer excludes. Your personal property, however, is still covered under a named-peril basis.

For the broadest protection, there’s the HO-5 home insurance policy, which covers both your dwelling and your personal property for all problems except those specifically excluded.

Still, there are problems that no home insurance policy will cover, such as damage resulting from:

  • Flooding
  • Earthquakes
  • Landslides
  • Mold
  • Infestations
  • Wear and tear
  • Nuclear hazard
  • Government action

However, you can buy flood insurance or earthquake insurance separately. In hurricane-prone states, you may also need separate windstorm insurance.

Talk to your insurer if you have specific concerns about weather-related risks in your area or other perils that aren’t represented on your policy. In many cases, you can add what are called endorsements to your policy — which will likely cost extra — to provide more protection.

Basic parts of a homeowners insurance policy

A homeowners policy is made up of several distinct coverages — some that are included automatically and others that you can choose to add.

Standard coverage

  • Dwelling protection: Covers damage to the home and attached structures, such as a garage.
  • Other structures protection: Covers stand-alone structures on your property, such as a fence, carport or toolshed.
  • Additional living expenses coverage: Also called “loss of use,” this helps pay for temporary relocation and basic living expenses such as meals if a covered loss forces you to vacate your home during repairs.
  • Personal property coverage: Pays to repair or replace belongings that are stolen or damaged in a covered loss — everything from your furniture to your curtains to your dishes.
  • Liability coverage: Pays out if you’re found responsible for others’ injuries on your property or away from home.
  • Medical payments coverage: Covers injury treatment costs for guests who get hurt on your property, or individuals you or your family members accidentally injure while away from home. This coverage kicks in regardless of who’s at fault.

Common optional coverages

  • Water backup coverage: Covers damage caused by a burst pipe or other issues related to your abode’s plumbing. Note that this coverage does not cover flash floods, only water that comes from the ground up. Depending on the insurer, this coverage may be included automatically.
  • Enhanced dwelling protection: Most insurers offer extra coverage for your house’s structure. In case your original coverage limits aren’t enough or there is a spike in the cost of construction, having enhanced dwelling coverage helps ensure you don’t have to dip into your savings to rebuild your home.
  • Identity theft expense coverage: Helps reimburse you for expenses you incur while recovering from identity theft. Depending on the insurer, this coverage may also include help from an identity theft advisor, who can deal with creditors and bill collectors and possibly restore your credit.
  • Scheduled personal property endorsement: Covers high-end items that exceed your regular personal property limits, such as jewelry or fine art.

This is only scratching the surface. Your insurance agent or company can tell you about other coverage types available that match your circumstances.

Choosing your coverage limits and deductibles

When it comes to dwelling coverage limits for your house, you want to cover the rebuilding cost of your home. Don’t confuse this with the purchase price or real estate market value. The rebuilding amount is based on local construction costs. If you insure the home for real estate market value, you risk not having enough funds for repairs, and could have to pay the difference on your own. Or you might end up over-insured.

To get an estimate of your rebuilding cost, multiply the square footage of your home by local construction costs per square foot. Your home insurance agent or insurer should be able to help with calculating the replacement cost.

If you insure your home for just its real estate market value, you risk not having enough funds for repairs.

For personal property, you generally want coverage limits that are at least 50% of your dwelling coverage amount, and your insurer may automatically set your limit that way. However, you can lower this limit if needed or purchase extra coverage if you think the limit isn’t enough to cover your belongings.

The best way to pinpoint how much it would take to replace all your stuff is by taking a thorough home inventory. An inventory record can also come in handy later if you have to make a claim and need to know exactly what you lost.

While home inventories can be a lot of work, using an inventory app like this one from the Insurance Information Institute can speed things up.

Replacement cost vs. actual cash value

When deciding how much homeowners insurance to buy, you’ll need to choose between replacement cost or actual cash value.

Replacement cost coverage — the more expensive option — does not factor in depreciation when reimbursing you for stolen or damaged personal items. It pays to replace your belongings with new, similar items, up to your coverage limit.

Actual cash value, on the other hand, bases claims payments on the depreciated value of your belongings. In other words, you get back the amount your valuables were worth at the time of the loss. Actual cash value is cheaper but offers less coverage.

Understanding deductibles

Homeowners insurance includes a deductible for property damage, which is the amount that’s deducted from claims payments. Instead of selecting a deductible for every type of claim, you can choose an all-peril deductible that applies to several incidents, whether it’s a stolen laptop or a burst pipe.

Each time you receive a claims check, your insurer subtracts your deductible amount. For instance, if you have a $1,000 deductible and file a claim for roof repairs to the tune of $10,000, your insurer would issue a payment of $9,000 and you would be responsible for the remaining $1,000.

Depending on the insurer, you may have a separate deductible for claims involving wind and hail. Liability claims generally don’t have a deductible.

How high should you set your deductible?

The typical home insurance deductible is between $500 and $1,000. Choosing a higher amount will usually reduce your premium. However, you’d have to shoulder more of the financial burden if an incident occurs. Going lower with your deductible, on the other hand, means you might have a higher premium but your insurer would pick up nearly the whole tab after an incident.

The cost of homeowners insurance

To determine your home insurance price, insurers typically look at the following:

  • Rebuilding cost of your home.
  • Age of your home.
  • Distance between your home and the nearest water source.
  • Fire protection rating of your city.
  • Your claims history and the claims history of others in your neighborhood.
  • Your coverages, limits and deductible.
  • Items meant for fun or recreation that pose major injury risk, such as pools or trampolines.

The average annual home insurance premium in the U.S. as of 2013 was $1,096 a year. But prices can skew much higher or lower depending on location. In Oregon, Utah and Wisconsin, the three most affordable states for home insurance, rates were between $568 and $665 a year. Meanwhile, in the three most expensive states, Florida, Texas and Louisiana, annual average rates were all over $1,800, according to the Insurance Information Institute.

What you’ll pay for homeowners insurance can vary greatly based on where you live.

If you’re concerned that your premium is too high, there are easy ways to save on homeowners insurance. For example, many insurers offer a discount for bundling your home and auto insurance. You might also get a lower rate if no one in your house smokes or if you have common safety features, such as burglar alarms and deadbolt locks.

Before getting too stressed over the cost of your policy, remember this coverage gives you considerable bang for your buck. After all, the premium you pay will be a fraction of the amount it would cost to rebuild your home from the ground up and replace all of your possessions.