Recently, winter storms left a path of devastation across Texas and much of the US. Homes lost power during the coldest stretch of weather I have ever experienced in Texas. We simply weren’t prepared for what those kinds of freezing temperatures can do over several days. As a result, the temperature inside many homes dropped to well below freezing causing water pipes to burst, sometimes with severe consequences. Following the aftermath of this storm, homeowners are relying on their insurance policies to mitigate the financial hardship caused by this disaster. One question many have probably not considered until now is “Do I have enough coverage?”
How Much Is Enough?
Homeowner’s insurance coverage is based on property value. There are three ways to value a home: market value, actual cash value and replacement cost value. Market value is what the property would sell for on the real estate market. Actual cash value is what the property is worth after adjusting for wear and tear. Replacement cost value is what it would take to rebuild the house if it were destroyed. Each of these can be different values. The key is that if your coverage is less than the cost to replace your home, the insurance company does not have to pay more than the contract amount. So if you have $250,000 in coverage and your house is destroyed by a tornado, the insurance company only has to cover up to $250,000.
Usually, insurance companies require owners to maintain coverage of at least 80% of the replacement value of the home (80% rule). Remember, this is the replacement value of the house only, not the land because the land doesn’t get destroyed.
Jack and Jill Smith bought a home in the Texas Hill Country for $300,000. The house sat on half an acre worth $100,000, and the house itself cost $200,000 to build. Being responsible homeowners, Jack and Jill purchased $200,000 in coverage with a $10,000 deductible for their new home. If something happens to their home, they would pay up to the $10,000 deductible, and then the insurance company would pay up to $200,000 to replace the home.
Most people know how much coverage they need when they buy a home, so this usually isn’t an issue when a home is first purchased.
The Danger of Property Value Appreciation
The hidden danger comes when you own a home for a long period of time and home values and replacement costs go up. If you are like most people and don’t track home values and the cost of construction closely when you aren’t shopping for a new home, inflation can turn that 100% coverage into something less than 80%.
A few years pass for Jack and Jill. Their kids grow up in the Hill Country home and go off to college. When they bought their home it was on the outskirts of a growing city, but over the years the area has attracted a growing business economy. Suddenly companies like Eddison Automotive and Rainforest Retailers announce they are moving their headquarters just down the road. The housing market explodes with new neighborhoods popping up everywhere. Home values triple since they originally bought their home. Jill calls their insurance company and increases their coverage to $600,000 (100% of the replacement value). That summer a wildfire breaks out in the woods behind the neighborhood. Their house and the home of their neighbors, the Jones, are burned to the ground. The Jones’ house was a mirror floorplan of the Smiths’ and they moved in a month after the Smiths did. While surveying the wreckage and talking to Dan Jones a few days later, Jack finds out Dan had been planning to update his homeowner’s policy, but never got around to it. So how much will the insurance company cover for each house? Jack and Jill had full coverage of $600,000 and they will pay the $10,000 deductible while the insurance company will cover $590,000. Dan and Sue Jones only had $200,000 of coverage, but their home’s replacement value is $600,000 (33% coverage), so the insurance company will only cover $245,833. (Loss – Deductible) x Amount of Coverage / (Replacement Value x 80%)
The moral of the story is check your coverage every few years and make sure it hasn’t been eroded by inflation or home value appreciation.
If you have any questions about this topic, or have a burning question about a different finance question, feel free to reach out and ask me a question. It might even become my next blog topic. If you would like help aligning your personal finances to achieve the life of your dreams, please schedule an introductory call and I would love to speak with you.