As a homeowner, you know your homeowners insurance policy covers any losses you suffer in the event of a disaster or other emergency.
But do you know how much coverage you really need to carry in order to receive full compensation in the event of a disaster? And do you know what happens when you aren’t carrying enough coverage—and how to fix this?
As a holistic financial advisory firm, part of our job is to ensure that every client is appropriately insured at all angles. Your home is one of your most valuable assets, perhaps your most valuable asset. It’s important that you carry appropriate insurance coverage for your home, and from a financial standpoint, it’s critical that you get the most out of your policy.
Key Homeowners Insurance Terms
Two of the most important homeowners insurance terms to know are:
Replacement cost. An item’s replacement cost is the amount needed to repair it with similar quality materials. Depreciation is not factored into an item’s replacement cost.
Actual cash value. This is the amount needed to repair or replace an item minus depreciation. So to give an example, let’s say you want to replace your two-year-old basement carpet after the basement is flooded in a storm.
Because the carpet has experienced wear and tear unrelated to the flood in the two years since you had it installed, you can’t expect to be reimbursed for the full amount you paid when you first bought it. Instead, you can recover the carpet’s actual cash value, which an insurance adjuster calculates by subtracting its depreciation amount from its replacement cost.
Put into a formula, this looks like: Replacement cost – depreciation = actual cash value.
The 80% Rule
In most cases, “full coverage” is defined as 80% of the home’s replacement cost. When you initially purchase a homeowners insurance policy, you’re usually required to buy a policy that provides full coverage.This is known as the 80% rule.
So what happens when your home’s value goes up? If you own a home, you’ve likely seen its value increase over the years as you’ve upgraded and improved it. If your home’s value has increased significantly, keep that 80% rule in mind. With a higher-value home, you need to increase your insurance coverage to 80% of its new value.
Here’s what can happen if you don’t adjust your coverage: In the event of a disaster, your insurance provider might only cover the difference between the coverage you have and 80% of the home’s replacement cost. Here’s an example to illustrate this scenario:
You bought your home for $300,000. As per the 80% rule, you needed to purchase insurance for $240,000.
In the years that follow, you renovate your home. A decade after you bought it, the cost to repair your home is $400,000. But then a tornado rips through the neighborhood, landing a 100-year-old oak tree through your roof.
The damage will cost $100,000 to fix.
You go to file a claim with your insurance provider and find that you’re still only covered up to $240,000…60% of your home’s replacement cost. So to determine how much they’ll cover toward repairing the damage, your insurance provider divides the amount of coverage you have by 80% of your home’s replacement cost. In this scenario, that’s 240,000/320,000 = 0.75.
So instead of paying the full $100,000 (minus your deductible), your insurance provider would only pay $75,000 minus your deductible.
When Should I Adjust my Insurance Coverage?
Here’s where it can be a bit tricky to determine when to adjust your coverage. In the past two years, house prices rose dramatically. But a more expensive house doesn’t necessarily mean you need to buy more insurance coverage.
The 80% rule is that you need to cover 80% of the home’s replacement cost. Factors that impact a house’s replacement cost include:
- Construction material prices
- The house’s square footage
- The value of the home’s components and construction materials
- Construction labor costs
For example, installing new windows can increase your home’s replacement cost, because new windows are generally of higher quality than older ones and haven’t depreciated much yet. Your home’s appraised value can be a jumping-off point for determining your home’s replacement cost, but the replacement cost isn’t always going to be 80% of the home’s value.
So how can you know if you’re carrying a sufficient amount of coverage?
Check up on it.
Every year, take a moment to look over your policy in detail. Know what’s covered and how much you are covered for. Then, take a look at local building and materials costs. Determine what it would cost to make specific “big” repairs and replacements, like your roof, if you had to make them today.
Then, take inventory of all your appliances, housing materials (siding, flooring, etc) and other objects covered by your homeowners insurance policy. Keep a record of how old they are and what they would cost to repair or replace right now. This can help you determine how much to adjust your policy and in the event you do need to file a claim, it can help you streamline the process.
After your annual “policy checkup,” you can discuss your policy with your insurance provider. A representative can discuss your policy with you in detail and help you determine if you need to adjust your coverage level.
Reach out to an Experienced Wealth Advisor
Determining how much homeowners insurance you need to carry can be a complex, nuanced subject. It also has far-reaching repercussions that can leave you on the hook for thousands if you aren’t sufficiently covered.
Our team can help you determine the homeowners insurance policy that’s the best fit for your home. Interested in learning more? Schedule your initial consultation with a member of Sax Wealth Advisors today.
About the Author
Joseph Piela, CFP® is a Partner and Wealth Advisor at Sax Wealth Advisors with over 20 years of experience. Daily, Joe helps high-net-worth individuals and families, professionals and closely held businesses reach their financial goals through the creation and maintenance of holistic financial plans. He can be reached at firstname.lastname@example.org.