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What Is Homeowners Insurance and How Does it Work?

What does your ideal home look like to you? Maybe it's Cape Cod style and nestled in the heart of New England. Or perhaps it's farmhouse-style, complete with rustic exposed brick and a porch. Regardless of whether it's your first home or your third, each one is important – sentimentally and as an investment. So, it's vital that you protect it from potential harm.

Homeowners insurance is the main method homeowners can use to safeguard their property from disaster.

Homeowners insurance is the main method homeowners take to safeguard their property from disaster. And it's often required by lenders. However, it's easier to understand the significance of something when you break it down. With that in mind, here is a guide on homeowners insurance and how it works.

What Is Homeowners Insurance?

Homeowners insurance, sometimes called home insurance, is a type of insurance policy that offers protection for a private residence. It insures the structure of your house as well as your belongings from damage, destruction and other disasters. So, if a fire sweeps through your neighborhood or a burglar makes off with your electronics, you have funds to replace or repair what you lost without reaching into your pocket.

In addition, most standard homeowners policies also help you pay for legal expenses. They offer these funds in the case that you are liable for someone else's injury or damage to their property.

Homeowners Insurance Claims and Deductibles

When something happens that's covered under the homeowners insurance policy, homeowners can file a claim. However, they must pay out-of-pocket up to a certain amount, called the deductible. Once they hit that number, the coverage kicks in and the insurer starts paying.

For example, if you have $3500 worth of damages for a covered peril, and you have a $500 deductible, you will pay the $500 and your insurer will pay $3,000.

The company won't contribute an endless amount of cash, though. Every homeowners policy includes a liability limit, which sets the amount of funds the policyholder can receive. Of course, if the standard amount is not enough, they can opt for a higher limit. But this does come with an increased homeowners insurance cost.

Replacement Cost vs. Actual Cash Value

Buying homeowners insurance helps you rebuild your home in the event of a catastrophe. But your homeowners insurance provider won't just write you a blank check. The amount they give you will depend on the type of coverage you choose on top of the rebuilding costs.

Buying homeowners insurance helps you rebuild your home in the event of a catastrophe without footing the entire bill.

Considering that, one of the most crucial decisions for any homeowner is finding the right coverage for the job. You need a policy that allows you sufficient finances to rebuild your home, which isn't simple. Several factors can drive up costs between the time you purchase a policy and when you need it.

Actual Cash Value

Actual cash value (ACV), or market value, coverage is the standard for many homeowners insurance companies. Essentially, the homeowners insurance company takes the replacement cost and reimburses you for it, minus any depreciation. In this way, it represents the monetary amount you could earn if you were to sell the possession or structure on the market. It uses factors such as wear and tear or age to determine the depreciation.

These policies are traditionally lower cost than replacement cost policies. However, they also result in a smaller reimbursement amount.

Replacement Cost

The replacement cost value (RCV) functions differently from actual cash value and exactly like how it sounds. It is the amount of money needed to repair or replace your home or belongings at today's costs. So, if you lose your TV, it pays for the cost of a comparable model.

Replacement cost for your home can be tricky to figure out. It covers the cost of labor as well as materials. In some cases, it may even pay for additional living expenses if your family has to live elsewhere during repairs.

Many insurance companies use replacement cost homeowners insurance as their default, but it also costs more.

How Much Does Homeowners Insurance Cost?

Many factors affect the price of your homeowners insurance policy. For one thing, the value of your home is a big factor and so is the location of the home and your credit score. In some states, people pay low homeowners insurance rates compared to the rest of the nation. For instance, Ohio, Missouri and South Dakota pay an average of $900 annually. Residents in Maryland, Virginia and Delaware pay the highest rates, with premium averages ranging from $2,559 to $3,000.

Types of Homeowners Insurance Coverage

Homeowners insurance policies actually comes in a range of types, called "policy forms." Homeowners purchase various versions for different reasons. For example, some provide a greater degree of coverage than others. So, it's important for potential or even current homeowners considering switching policies to know the difference.

The extent of each type's coverage can change depending on the state or homeowners insurance carrier. However, these descriptions are relatively standard:

HO-1: Basic Form

HO-1 offers the most basic form of homeowners insurance coverage. The structure of your home and your personal belongings are insured for their actual cash value. In addition, it offers protection against damage or loss, but only in the case of specifically named perils. The list is shorter than the one offered through the HO-2 form, even. HO-1 policies cover 10 listed perils:

  • Fire or smoke
  • Explosions
  • Lightning
  • Hail or windstorms
  • Theft and malicious mischief
  • Volcanic eruptions
  • Damage from aircraft
  • Damage from vehicles
  • Riots and civil commotion

Overall, the bare amount of coverage in an HO-1 type makes it relatively unpopular.

HO-2: Broad Form

Like HO-1, HO-2 homeowners insurance pays only to protect against specific damage. It must be the result of one of the policy's listed perils. However, HO-2s, also called "broad form" policies, are a small upgrade from the most basic form. HO-2s also cover your home for its replacement cost in addition to insuring your personal property for its cash value.

It also includes six more cited perils in its policy list, which are:

  • Falling objects
  • Weight of snow, sleet, or ice
  • Pipes freezing
  • Damage from electrical current
  • Water damage from home systems
  • Water heater cracking, burning, and tearing

HO-3: Special Form

You may see HO-3 insurance policies referred to as "special form" policies. They're the most common option among homeowners. In particular, they account for the majority of policy types on single-family homes.

HO-3s provide coverage against damage from almost any cause. Although there will be certain exceptions, such as earthquakes and floods, it's more inclusive than either the HO-1 policy or the HO-2 policy. In total, you can expect it to protect against 16 perils, which come from the HO-1 and HO-2 policies combined.

Ho-3 policies default to the same extent of coverage as an HO-2: it pays for your home at its replacement cost and the cash value for personal property. However, your insurer may allow you to change that. In which case, you can pay additional money to insure your personal property for its replacement cost.

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HO-4: Contents Broad Form

You might know HO-4 policies under their more common name: renters insurance. These policies are designed specifically for individuals renting their current dwelling.

HO-4 policies provide two forms of coverage. First, it protects your personal property, both on the property and off. And, second, it covers any expenses through liability coverage. In addition, if one of the named perils on the policy damages your rental property, then the HO-4 form will pay for additional living expenses. So, you have funds to live somewhere else temporarily while your landlord repairs your home.

HO-5: Comprehensive Form

As the name suggests, HO-5 form homeowners insurance is the broadest and most inclusive version of insurance for single-family homes. They're generally similar to HO-3 policies, but there are some significant differences.

For example, HO-5s insure the dwelling and personal property for their replacement cost automatically. So, you don't have to pay additionally to update your personal property coverage. The coverage it provides for both the structure and your personal belongings also comes as all-risk coverage.

Finally, HO-5 policies include higher coverage limits for higher-priced possessions. Expensive belongings tend to come with strict coverage limits, but HO-5s make it easier to insure these items. That helps if you own items like furs, jewelry, and other luxury goods.

People usually purchase HO-5 insurance when they own a high-net-worth property and need extra protection. Some homeowners insurance companies specialize in this type of coverage.

HO-6: Unit-owners Form

Alternatively referred to as condo insurance, HO-6 policies are for people who live in a co-op or condominium. The actual amount of homeowners insurance coverage may vary for these individuals since their condo may come with HOA insurance.

HOA insurance, otherwise known as the "master policy," generally covers the condo's structure, building common areas, and the structure of the building. However, it doesn't usually include any upgrades to the dwelling itself, like new light fixtures. In that case, you'll need dwelling coverage. Your condo policy may also include other forms of coverage, such as personal liability, loss assessment coverage and loss of use.

HO-7: Mobile Home Form

HO-7 home insurance functions very similarly to HO-3 policies. But, instead of covering a single-family home, it applies to mobile homes.

Different types of mobile homes fall under the HO-7 policy, including:

  • Trailers
  • Modular homes
  • Sectional homes
  • Park model homes and RVs

HO-8: Modified Coverage Form

Your home may not meet the standard requirements needed for the more common types of homeowners insurance. This usually applies if the home is high-risk, outdated, or already damaged. If you don't update the home to meet HO-3 policy requirements, you can still qualify for HO-8 homeowners insurance.

HO-8 policies function similarly to HO-1 basic form policies. They only insure your home for its cash value and cover 10 named perils.

While that may limit your protection, you may be more interested in the home itself. If your house has a longstanding history you want to preserve without modernizing it, a HO-8 policy is useful. For example, owners of dwellings over the age of 40, historic homes, and houses listed on the National Register of Historic Places may want to consider this option.

What Does Standard Homeowners Insurance Cover?

Homeowners insurance covers your home as well as some of your other property. There are six types of coverage you generally encounter when buying a standard homeowners insurance policy.

Dwelling coverage pays for necessary repairs for damages to your home and any attached structures, like a porch. It usually covers enough to rebuild your home.

Personal property pays to replace or repair your belongings in the event of theft or damage. It often includes coverage up to 50- to 70% of dwelling coverage.

Liability coverage provides funds if you're liable for someone's injury while they're on your property or damage to theirs. The standard coverage amount is usually between $100,000 to $500,000.

Medical payments coverage is similar to liability coverage. If someone is injured on your property or because of a member of your household, it pays for their medical bills. The standard coverage amount usually sits between $1,000 to $5,000.

Other structures coverage helps you protect stand-alone structures on your property, like a shed. It usually covers up to 10% of your dwelling coverage amount.

Additional living expenses pays for temporary livings costs you may have while waiting for repairs to your home. It typically covers up to 20% of your dwelling coverage amount.

What Is Not Covered by Standard Homeowners Insurance Policies?

Any number of things could damage, destroy, or otherwise affect your home. Even a comprehensive homeowners insurance policy can't cover every single possibility. However, there are certain types of events that policies usually exclude. Some of the more common disasters left out of a standard homeowners policy include:

  • Flooding
  • Earthquakes
  • Infestations
  • Nuclear hazard
  • Power failure
  • Neglect or wear and tear
  • Government action

If you live in an earthquake-prone area, you can buy an earthquake insurance policy that covers the resulting damage. Other common add-on policies include flood insurance and windstorm insurance.

That's not all, either. You can sharpen up the range of coverage your policy provides by purchasing endorsements. These come at an additional cost and vary by insurance company and location. The most common you might see are equipment breakdown coverage, identity theft coverage, home business coverage, scheduled property coverage, water backup coverage, and food spoilage coverage. 

Is Homeowners Insurance Required?

There is no law that states you must purchase homeowners insurance. So, legally, you can go without a policy. However, many of us need financing to buy our home. And any individual or entity that lends you money for that has a financial stake in your house.

Typically, mortgage lenders require you to purchase homeowners insurance before they're willing to approve you. A lender may even buy a policy on your behalf. Mortgage lenders do this to protect their investment in the property. So, you will have to buy homeowners insurance if you want to borrow any money. Once you pay off your mortgage, no one can force you to continue paying for your policy. However, homeowners coverage is a wise investment, since it ensures your largest asset is taken care of in case of a disaster.

How Much Homeowners Insurance Do You Need?

You should buy enough coverage to protect your assets.

You should buy enough coverage to protect your assets. A reliable homeowners policy will include dwelling coverage to limits that would help you rebuild your home in case it's destroyed by a covered peril. You'll also need personal property cover, loss-of-use coverage (also called "additional living expenses) in case your home becomes uninhabitable. The liability portion of your coverage will protect you in case someone is hurt on your property or if someone sues you. There are also optional coverages that are important to consider as well, especially if you have valuables in the home

Finding the Best, Most Affordable Homeowners Insurance

Purchasing homeowners insurance is a big step in your life. And there's a lot that goes into it. So, take your time to research. Choosing the right policy should accommodate your financial situation and the needs of your home.

If the only thing holding you back from a homeowners policy is the cost, know that you have options. Many insurance companies offer a varied list of discounts to reward you, such as when you install a home security system or hold multiple policies with a company. In addition, certain factors can lessen the cost of your insurance premium, like the age of your home, location, and your credit score.

If you're unsure which insurance company will offer the best bang for your buck, consider using SmartFinancial, a free service that pairs you with an insurance agent in your area offering the lowest rates on the market and reliable coverage. Just enter your zip code below to get started.

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