Everything you need to know about homeowners insurance
Homeowners insurance basics
- Mortgage lenders will require you to have a homeowners insurance policy.
- The required premiums are normally set aside in an escrow account until due.
- In some cases, the borrower can opt out of escrow and pay the insurance company directly.
Homeowners insurance protects your house in the event of a fire, natural disaster or other calamity that can result in serious damage to the property. It oftentimes also covers your property in case of theft, as well as provides liability coverage if someone is injured on the property.
You are not legally obligated to have homeowners insurance on your house, but many lenders will require proof of insurance as part of the home mortage closing process. Because your home is one of your most important assets, however, it is always wise to do so. If you buy your house in cash, retaining homeowners insurance is up to your discretion.
If you are financing your home with a mortgage, however, your lender will mandate it.
How is it paid?
With many government-backed loans and conventional mortgages exceeding 80 percent of the home’s value, homeowners insurance payments are typically paid using a mortgage escrow account set up by your lender.
In that case, your homeowners insurance premium is usually structured as part of your mortgage payment, which — in addition to your principal and interest — also typically includes property tax and private mortgage insurance (PMI) or Federal Housing Administration (FHA) mortgage insurance, depending on your loan conditions.
Upon receiving your mortgage payment, your lender will transfer the portion dedicated to the property tax, mortgage insurance and homeowners insurance payments into the escrow account, from which the lender will later pay those bills when due.
The cost of property tax and homeowners insurance premiums are not fixed throughout the life of your mortgage, however, and typically change annually. Your lender estimates how much you will owe in taxes and homeowners insurance, divides that figure by 12 and charges you accordingly each month. This means that at the end of the year you may owe additional money or receive a reimbursement, depending on the final calculation of costs.
The primary benefit of an escrow account for the borrower is convenience. Dividing your insurance costs into monthly payments makes staying on top of bills more manageable because you won’t be faced with a large lump-sum payment for the year. Lenders get the peace of mind that the house is insured and all necessary payments are in order.
There is an added benefit for the lender, however. As the insurance money is being paid up-front several months prior to being due, the lender gets to earn interest on the funds in escrow while waiting to make the payment.
An alternative option
While an escrow account is the most common arrangement for paying homeowners insurance and typically required by the lender, some lenders may allow the borrower to opt out of escrow and pay the insurance company directly. This will likely require the borrower to pay a waiver fee and also to have at least 20-percent equity in the home — giving the lender confidence that you are invested in the property enough to make your payments on time.
If you have private mortgage insurance, that can be canceled as well once you have 20 percent or more equity in your home. FHA mortgage insurance premiums, however, must be paid through the life of the loan and can’t be terminated unless you refinance the loan. Mortgage insurance provides protection to the lender in the event the homeowner defaults on the mortgage.
If you are confident that you can manage setting aside money on your own for your taxes and homeowners insurance and make the payments in full and on time, you may consider opting out of escrow in order to retain access to your money — and earn interest on it — prior to the bills coming due.
You also can save a significant amount of money if you pay your homeowners insurance up-front and in full directly to the insurance company. You as the borrower are ultimately responsible for the insurance payment and — while unlikely — lenders sometimes make errors when paying the insurance premium — for which you will be liable.
Discuss the escrow process when comparing lenders or when getting preapproved for your mortgage and consider your financial situation carefully. If you are concerned about being able to make your payments on time and see value in letting the lender earn interest on your money in exchange for the convenience factor, using an escrow account might be right for you.
Conversely, if you are financially responsible, want to hold on to your money and corresponding interest as long as possible, and prefer the added control of handling the homeowners insurance payment yourself, it may be a prudent decision to opt out of escrow if your loan terms allow it.