When you take out a mortgage, your lender places a lien on your property which enables the lender to take ownership of your home if you default on your loan. In order to protect the collateral from damage, lenders typically require homeowners to purchase an insurance policy that provides a level of coverage that at least equals the amount of the loan. In some instances federal laws may require you to buy flood insurance for your mortgaged home.
Homeowners Insurance Coverage
A homeowners insurance policy protects you from certain perils such as fires and storms, but your policy may exclude coverage of other events such as flood damage. Insurance coverage comes in one of two forms: replacement cost or cash value. If your policy provides you with replacement cost coverage, the insurer makes a payout based on the cost of repairing or replacing your home. If you have a cash value policy, the insurance company makes a payout based on the actual value of your home. Replacement polices typically cost more because cash value policies often result in minimal payouts on homes that are in a state of disrepair.
Mortgage companies typically require you to escrow your insurance and taxes. This means that your monthly mortgage payments consist of principal and interest payments as well as monthly contributions toward the annual cost of your tax and insurance. The lender pays the insurance on your behalf and receives notification from the insurer any time that your premium rises or falls. If your lender enables you to self-escrow, you have to provide the lender with evidence that you have insurance in place.
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When you take out a mortgage, the closing documents normally contain a document that states that your lender can buy homeowners insurance on your behalf if you ever fail to maintain your insurance coverage. Lenders receive notification from the insurer if your coverage comes to an end and immediately buy a new policy to cover your home. Normally, the lender charges you a premium for this coverage and adds the cost of the new policy to your monthly mortgage payment.
The Federal Emergency Management Agency regularly produces flood maps that enable homeowners and lenders to see which areas of the nation are at risk of flooding. Legally, banks cannot write loans or increase existing loans on a property that is in a designated flood zone unless the homeowner buys a flood insurance policy. The policy must at least cover the amount of the loan. Flood insurance covers damage not covered by standard homeowners policies, such as structural damage caused by water. People living in coastal areas typically have to buy flood insurance.