When you buy a house or refinance a mortgage, your mortgage company will want to confirm their investment (your home) is insured. However, the homeowners insurance they want and the property insurance you need may be different.
What I mean is sometimes the mortgage company may require homeowners insurance for the full mortgage amount. On the surface, that makes sense. But if you understand how insurance pays claims, that may be a waste of your money. And Pennsylvania has a law in place that prohibits the practice. More on that below. First you need to understand how insurance claims work.
Let’s look at a claim example to illustrate the point. We’ll use nice round numbers.
Let’s say you’re buying your new home for a cool million dollars. It sits on 10 acres, has a large separate garage and above ground pool. Nice place, congratulations. You call your insurance agent and they estimate the replacement cost of the house itself at $600,000. Therefore they insure the property for $600,000.
Six months later, you have a total loss fire. The house is destroyed. The garage and the pool are undamaged. Then along comes the insurance company to adjust the claim. They cut a big fat check for $600,000 to replace your home. They also pay $300,000 to replace your damaged belongings. And lastly, they pay your expenses to live elsewhere for a year while your home is being reconstructed.
All told, the claim ends up being $980,000 even though you only bought $600,000 of coverage on your home. You’ll notice that $1,000,000 of coverage never came up in this scenario. But the full claim was still paid in full. That’s because home insurance is based on the replacement cost of the home. The garage, the pool, your belongings and the extra cost to rent another home are all separate limits. The cost of the land isn’t insured at all. The land is still there and still valuable after the fire!
We’ll take the same example as above. You’re paying $1 million, 10 acres, pool, garage, etc.. Your mortgage company rejects your insurance and tells you to increase the building limit to $1 million to cover the cost of the loan. So now your price goes up about 50% on your homeowners insurance.
The same claim happens. And guess what? The claim is paid exactly the same. Your home insurance company isn’t going to pay to replace more than you had. The policy will make you whole again, not let you turn a profit and build a bigger house.
Is my lender allowed to make me over-insure my home?
So the answer is no… But..
In Pennsylvania, we have the Mortgage Property Insurance Coverage Act (Act 51 of 2008). This prohibits lenders from requiring more insurance than the replacement cost of buildings. So this doesn’t address the entire issue. But it does mean they can’t make you insure the value of the land.
Now the problem with this law is that it is a state law. That means it only applies to banks regulated by Pennsylvania. Banks that have ‘National’ or “N.A. (national association)” after their name are regulated federally. The Office of the Comptroller of the Currency (OCC). As of the time this was written, we were unaware of any restrictions on such requirements with the OCC.
What if the loan is for less than the rebuild cost?
Our agency is in Pittsburgh. That means a lot of older homes. So often times the replacement cost of the house is often more than the market value.
If this is the case, you won’t run into issues with your mortgage company. They typically just want the building insured for their loan amount. However, it is always in your best interest to insure your property to its full replacement cost. I can’t stress that enough.