Written By: Joe Botta, CHC®, AFC®
For most clients, buying a home for the first time is a complex and potentially anxiety inducing experience. In addition to the large sum of money involved, first time (i.e. inexperienced) homebuyers are dealing with professionals in a business with which they are almost entirely unfamiliar.
Most buyers quickly become aware of the main players in a real estate transaction. These players include the lender who provides funds for a fee that are needed to afford the home. There is the realtor or real estate agent who helps buyers select the home that meets their needs in an area they wish to live. Finally, there is the settlement agent or an attorney who assembles the paperwork requiring transfer of ownership from buyer to seller and documenting the amount of funds paid by the parties in the home buying transaction.
There are other key players too. Perhaps not as well known, but they are also important professionals such as a home inspector, real estate appraiser, and insurance representative. The types of insurance policies that homeowners should be aware of are listed and described below. They include the following types of insurance policies:
- Mortgage Life
Title insurance protects lenders and real estate owners against property loss or damage they might experience because of liens, encumbrances or defects in the title to the property. Title insurance provides coverage for problems or hidden risks that affect ownership rights that may have occurred before the borrower takes title to the property.
The most common types of claims filed against a title, according to Don P. Foster, a partner for Klehr Harrison Harvey Branzburg and Ellen in Philadelphia(Insure.com, “The Basics of Title Insurance”), are back taxes that were somehow overlooked by the title company in researching a sale, easements, liens including mortgage loans and home equity lines of credit, and conflicting wills related to the property.”
Lenders usually require title insurance to close on a mortgage, but the lender’s version only protects the lender up to the amount of the mortgage. Homebuyers have the option to purchase a homeowner’s policy. An owner’s title insurance policy may protect the full value of the home.
The homeowner pays the one-time premium for the lender’s policy and also for the owner’s policy, if selected. Owner’s title insurance, while not required, should be considered to protect the owner’s interest on the property. Title insurance companies normally offer a reduced rate for a homeowner policy when purchased at closing along with the lender’s policy. More information can be found at www.scc.virginia.gov/boi/pubs/ titleguide.pdf.
Mortgage Insurance covers the lender in the event the buyer fails to meet the required home payments and as a result defaults on the mortgage. While it is a buyer’s responsibility to pay for this insurance, it actually covers the lender since the lender bears the risk of loan default. Not every borrower needs to pay for mortgage insurance. Usually if you make a down payment of 20 percent or more, you don’t need mortgage insurance. Mortgage insurance is provided by the following:
- Conventional loans, also called private mortgage insurance (PMI) through private companies or
- Government backed or guaranteed through the Federal Housing Administration (FHA) or Veterans Administration (VA). FHA mortgage insurance is referred to as Mortgage Insurance Premium (MIP), while VA mortgage insurance is a one-time funding fee (FF). Homebuyers using an FHA-insured loan must obtain mortgage insurance.
PMI buyers can request cancellation of mortgage insurance when the loan-tovalue ratio drops to 80 percent. However, the lender is required to cancel private mortgage insurance when the loan-to-value ratio drops to 78 percent. Private mortgage insurance fees vary from around 0.3 to 1.5 percent of the original loan amount per year, depending on the size of the down payment and the buyer’s credit score, according to Holden Lewis at Bankrate.com.
For MIP, the FHA requires an upfront payment and annual premium and rates are subject to change. This upfront premium is paid when the borrower gets the loan and it can be financed as part of the loan amount. The “annual” premium is paid monthly. It varies based on the length of the loan, the amount borrowed and the initial loan-to-value ratio, or LTV. According to the Department of Housing and Urban Development ability to cancel the FHA monthly mortgage insurance premium is based on several factors including the loan term, LTV, and regulations in place when the loan is closed, or the case number was assigned, as applicable.
The VA requires a one-time funding fee, so there is no annual premium cancellation. Rates on VA-guaranteed loans are subject to change. To obtain a certificate of eligibility for a VA guaranty loan, a service member must have been discharged under conditions other than dishonorable and meet certain service requirements. Active duty members must have 90 days of continuous active service. The spouse of a Veteran may also be eligible for a VA guaranty loan. http://www. bankrate.com/finance/mortgages/getting-valoan.aspx; www.HUD.gov; http://pubs.ext. vt.edu/354/354-173/354-173.html
Homeowners insurance (also referred to as “Hazard Insurance”) generally covers the physical structure of the home and personal belongings. Lenders usually require this insurance as a condition of lending to the homebuyer the funds needed to purchase a property. Consider a Replacement Cost Value (RCV) policy rather than an Actual Cash Value (ACV) policy.
Homeowners insurance usually includes but is not limited to damages from fire and smoke, lightning, hail, theft and vandalism, and also protects the homeowner from certain liabilities. An example of a covered liability would be when a neighbor accuses a homeowner of being negligent because, for example, the neighbor slipped on the front step and broke his ankle alleging that the homeowner failed to clear snow and ice from the front step, faulting the homeowner and filing a lawsuit.
Coverage can vary from state to state, so it is crucial to fully understand what your specific policy covers. Having an up-to-date inventory of your home’s contents and their value will ensure that you can accurately identify losses if necessary.
An interesting fact about hazard insurance is that it can cover losses occurring outside the home. Suppose your car is broken into while you are on vacation at the beach and valuables were taken. You would file a claim to replace those valuables against your homeowners policy not your auto policy.
More information can be found at Rutgers Cooperative Extension http://njaes. rutgers.edu/Money/PDFS/session-ii.PDF (Money Talk: A Financial Guide for Women, NRAES-160) and http://www.nachi.org/ clue-reports.htm
While standard homeowners insurance may cover water damage from a leaky pipe or an overflowing washing machine, it doesn’t cover flooding. It is important to have protection from the floods associated with hurricanes, tropical storms, and heavy rains.
In 1968, Congress created the National Flood Insurance Program (NFIP) to help property owners financially protect themselves. The NFIP offers flood insurance to homeowners, renters, and business owners if their community participates in the NFIP. Participating communities agree to adopt and enforce ordinances that meet or exceed FEMA requirements to reduce the risk of flooding. Congress mandated federally regulated or insured lenders to require flood insurance on properties that are located in areas at high risk of flooding. A lender can require flood insurance, even if it is not federally required.
Flood insurance may have limitations on coverage, More information on flood insurance including the information on high flood prone areas can be found at FloodSmart.gov.
An umbrella insurance policy (also referred to as “exc1ess liability” insurance) simply adds extra liability coverage to your homeowners and auto insurance policies and can protect against expensive lawsuits. Umbrella policies start coverage only after you’ve exhausted your liability coverage under your homeowners or auto policy. For this reason an umbrella policy is relatively inexpensive.
Umbrella policies come into play in the rare event you are sued. You could be forced to pay a legal judgment from your current assets and future earnings. The policy can also pay for defense costs, which can quickly add up even if you win your case. It’s an inexpensive way to protect your finances from devastating lawsuits.
While many homeowners may find an umbrella policy useful and applicable, such a policy becomes even more important as the value of a person’s assets grow. Your net worth can be a starting point to determine if you need umbrella insurance. Determine if your existing policies cover the value of your net worth. If not, an umbrella policy may be for you.
Umbrella insurance policies may not extend coverage to all policies or incidents. Be sure to check coverage and exclusions. These policies are unlikely to cover punitive damages or damages as a result of a business enterprise, if not specifically written to cover a business.
Thorough coverage of Umbrella insurance can be found at Rutgers Cooperative Extension https://njaes.rutgers.edu/money/ pdfs/session-ii.pdf (Money Talk: A Financial Guide for Woman, NRAES-160).
Mortgage Life Insurance
Mortgage Life insurance is life insurance meant to pay off the home mortgage principal in the event that the insured dies. Typically it is a decreasing term policy where the remaining mortgage balance is paid to the lender, allowing those left behind to live in the home mortgage free, i.e. no more principal and interest payments. Yearly costs usually remain level. A medical exam is usually not required for a mortgage life policy and because it is usually issued regardless of the health of the insured, it can be relatively expensive. Consequently, a homebuyer should consider an Annual Renewable Term policy or a Level Premium Term policy.
With an Annual Renewable Term policy or a Level Premium Term policy the death benefit remains the same and doesn’t decrease with the mortgage. The owner determines the beneficiary and the beneficiary can use the funds remaining after paying off the mortgage for anything the beneficiary chooses, including not paying off the mortgage if the beneficiary has enough income for the monthly mortgage payment. As long as the policy owner keeps paying the premium, the insurance renews automatically each year. These policies normally require a medical exam to get the first year of insurance, but after that a new exam usually is not required.
Annual Renewable term policies are normally very inexpensive in the early years of coverage and then can greatly increase in the later years. If buyers know they will be in the home for just a few years (for example a two to four year military assignment), Annual Renewable term may be appropriate. Level Premium term policies are just that—the annual premium is the same over the life of the policy (e.g. 15 or 20 years) or as long as it is paid. If buyers want the consistency of a fixed payment and will be in the home for a longer time period, they should consider Level Premium term. Mortgage Life insurance buyers are paying a level premium for less and less coverage.
Term insurance is appropriate if you are seeking protection for a specific need such as a home mortgage that will end at a future date such as the life of the mortgage loan. Term insurance typically provides for the largest immediate death benefit amount for each premium dollar.
Many states publish Consumer Guides for mortgage life insurance. The state of Virginia publishes a comprehensive Guide at http:// www.scc.virginia.gov/boi/pubs/hoguide.pdf.
You can help your clients understand these six types of insurance so that they can better determine the insurance they might need in their particular circumstances. To fully understand what the specific policy covers for each type of insurance, clients should always carefully read and understand what is in the particular policy they may be considering.
Get a C.L.U.E. Report
According to the International Association of Certified Home Inspectors, the
C.L.U.E. report contains consumer claim information provided by insurance companies. C.L.U.E. stands for Comprehensive Loss Underwriting Exchange. C.L.U.E. reports let potential homebuyers know about water damage, mold, and other issues that can make it difficult or even prohibitively expensive to insure a home. For more information, visit http://www.nachi.org/clue-reports.htm.
Joe Botta is a personal finance counselor for Zeiders Enterprises, Inc. In 2011, he retired as Manager of the Financial Education Program in the Prince William County Office of Virginia Cooperative Extension. He continues his work with VCE as a volunteer. Joe is an Accredited Financial Counselor and Certified Housing Counselor and has a master’s degree in business administration from the University of Massachusetts. Joe retired from the United States Air Force in 1988.