In recent years there has been growth in the home warranty market yet consumers are still not well aware what exactly a home warranty policy is.
Many confuse the benefits and terms with those of a homeowner’s insurance policy or are unsure of what the differences are between the two. In this article we will cover the differences between the two products, go over some situations where one would cover vs. the other and also give you our recommendation on whether you should purchase one or both for your own home.
First let us go over each product individually so that we can then contrast them both.
What is a homeowner’s insurance policy?
A homeowner’s insurance policy protects the owner of a property primarily from damages that the home sustains due to a natural disaster or some other unforeseen circumstance.
Many people are familiar with homeowner’s insurance as it is generally a requirement put forth by the mortgage lender when a house is being purchased.
Since 88% of American buyers finance their home purchase, then you can see why it makes sense that most homes in the United States have a home insurance policy on them.
The bank won’t require you to keep a policy after you pay your mortgage off, but many homeowners choose to keep their insurance active just to keep their peace of mind and because it really is a prudent thing to have.
Think about why a mortgage lender requires you to have a homeowner’s insurance policy, as understanding their motivations will help you understand what a home insurance policy covers and what it does not.
The mortgage lender will typically finance over 80% of the value of a house in a typical purchase, usually with a 30 year term. The ideal scenario for the lender is for you to pay off your mortgage in the agreed upon term.
You get to own your house outright, the bank gets paid the mortgage plus interest, and everybody comes out happy on the other end. Now let’s wall through a couple of scenarios where the bank does not end up with an ideal outcome.
The most obvious and perhaps most common one is you default on your loan and the bank stops receiving payments.
This is not ideal for the bank, but at least the bank can repossess the house (remember the house is the collateral that gives the bank security in a mortgage loan) and sell it forward.
Now, the bank will almost always lose money in this process, but they would have lost even more money if they had not repossessed the house.
It is worth it to explore why somebody would default on their mortgage and stop making payments to begin with. The first thing that comes to mind is that the members of the household run into some kind of financial trouble that causes them to no longer be able to afford the mortgage payments.
In this case, the insurance policy typically does not come into effect and does not really make a difference for the lender. Let’s explore another scenario; in an economic recession it is common for houses and property markets to drop in value as there is less demand from consumers for houses.
In this case, it is possible that the homeowner may have a a debt with the lender that is larger than what the house is actually worth, particularly if they bought the house just prior to the economic recession. In this case, the insurance policy also will make no difference to the mortgage lenders.
Let us now explore a situation where the insurance policy does actually have some impact. Say a natural disaster unfortunately comes through an area and significantly damages a property.
To use some numbers as an example, let’s say the house was worth $250k and a storm caused $100k of damage to the house. Now, the homeowners likely do not have $100k of savings sitting around to put towards the repair of the house; after all they did finance the purchase of the home.
They could default on their loan and move away, but since they have their insurance policy they can make a claim to their insurance company and use the money to repair the home.
The lender is protected in this case because if they were to have to repossess the house they would have taken possession of a damage house and would suffer a large loss.
Seeing this example, you can understand that home insurance is really meant for catastrophic losses. It protects you the homeowner from losing your house after a catastrophe.
A home insurance policy; however, is not meant to protect your house from minor damages that may arise from a number of different reasons. A home warranty may cover some of those smaller items, and later on in this article we will discuss some examples.
What is a home warranty?
A home warranty, also sometimes known as an “extended home warranty” is a very different product than your standard home insurance policy. For starters, your bank or mortgage lender will not care at all whether you have a home warranty policy.
That is because a home warranty policy has nothing to do with the structure of your house, and it is all about the appliances within the house. In general terms, it might be useful to think about the differences between a car insurance policy and a car warranty.
The delineation between the two is actually pretty similar to the delineation between a home insurance policy and a home warranty. The best way to think about it is that your home warranty will pay for unexpected breakdowns that are bound to happen in your home.
What are some examples of accidents that could be covered under a home warranty policy?
The most common example, and the reason most consumers actually purchase a home warranty policy is to protect from large unexpected bills in the event of an Air Conditioning breakdown.
This is also the reason why most home warranty policies are actually sold in the summer.
What are some events that would be covered by the typical home insurance policy?
A home insurance policy will cover catastrophic losses such as losses due to a tornado or an earthquake. Most will not cover flood unless you purchase a specific flood insurance policy.
You should be aware that most home insurance policies carry a hefty deductible, typically 2.5% of the property value.