Post originally appeared on Business Insider 9/18/20, and can be found HERE.
Ever wonder what would happen if your house burned down and it was a total loss? Would the insurance company simply cut you a check for the insured amount on your homeowners policy? Do you even know what that amount is?
I would say most of us could only answer one of those questions for sure, and that is a major problem in our financial plans.
Do you have enough coverage?
In an ideal world, we should insure our homes based on 100% of the replacement cost of the home. Replacement cost means how much it would cost to build the exact house before our loss occurred. There are a lot of variables that can impact replacement cost, such as what building materials are used, any changes to building codes since construction, and items that may now be irreplaceable.
To get a general idea of what your replacement cost would be, multiply the square footage of your home by construction costs in your area. Certain places, like large cities, will likely have higher construction costs than suburban or rural areas, so do your homework.
What could happen if you don’t update your coverage regularly
Let’s say we did this like we were supposed to and we covered 100% of replacement costs on our home, but over the last 30 years we simply never got around to reviewing our coverage again, and oh yeah, we live in San Francisco where our home has wildly appreciated over the years. What happens if we have a fire with a total loss?
Most insurance companies require that we carry at least 80% of the replacement cost on our homes. This is actually pretty logical if you think about it since your premium is based on the amount of coverage you carry. If, throughout the years, you habitually underinsured your home, that means you also habitually underpaid the insurance company. It doesn’t make good business sense to go ahead and cover a claim that wasn’t actually insured.
In our scenario, we covered 100% of replacement cost when we purchased the home for $250,000, but our replacement cost now is $1,000,000.
After the fire and our total loss, we contact the insurance company requesting $1,000,000 to rebuild our home. If we were properly insured, the insurance company would simply cut us a check minus our deductible, which normally is around $5,000. So, we’d receive a check for $995,000.
However, in our scenario, the insurance company would send us a pro-rated amount based on how much insurance we carried. The insurance company would explain that we should’ve been carrying 80% of $1,000,000, or $800,000, but instead we only carried $250,000. That amount divided by $800,000 gives us 31.25% coverage. The insurance company will send us a check for 31.25% of $1,000,000, or $312,500. Oh yeah, minus the $5,000 deductible, so just $307,500.
This is why insurance is such an important part of financial planning and really serves as the foundation to any well-built plan. We could’ve had an emergency fund, retirement account, even 529s for our children/grandchildren, but we might have to tap into all those accounts now to cover our home rebuild. Never underestimate the importance of carrying the proper kind and amounts of insurance.
If you enjoyed this post you may also like: