The world of insurance is often a confusing one. There are a lot of things to consider, and there is typically a lot of jargon involved that does little to clear things up. However, one thing we can all agree on is that insurance is necessary, and also that it can be expensive.
Beyond that, though, there are still a lot of questions.
One of the most common questions we find people ask about insurance, especially homeowners insurance, deals with the deductible. What is it? How does it work? How does it affect your premium? And, perhaps most importantly, when you’re choosing a policy, which deductible should you go for?
Answering all these questions will help you not only make a smart decision when it comes time to selecting a deductible, but it will also help you better understand homeowners insurance in general, which will make you a smarter shopper who is more capable of finding the best deal.
Here’s everything you need to know about choosing your deductible.
What is a Deductible?
The deductible on your homeowners insurance is the amount of risk you’re willing to assume. It’s usually a set dollar amount, although it can sometimes be a percentage, and it’s what you will need to pay each time you make a claim before the insurance company will hand out some money.
In other words, it’s the amount of money the insurance company automatically deducts from any claim you make with them.
Here’s an example:
- If you have a policy with a $500 deductible and a storm comes in and causes $1,000 worth of damage to your home, you would be expected to pay half of the repair costs should you make a claim.
- If the damage done was less than your deductible, you would be 100 percent responsible for all the repairs you need to make. In this case, filing a claim is completely pointless.
Something important to remember in homeowners insurance is that your deductible applies to each claim you make. This is different from other types of insurance, specifically health insurance, where your deductible applies to a set period of time, usually a year.
With these types of policies, you pay out-of-pocket until you reach your deductible and then the insurance company pays the rest. But with homeowner’s insurance, this is not the case. You will be expected to pay your deductible with every claim you file.
Why Do Insurance Companies Use Deductibles?
Insurance companies use deductibles as a way of limiting the number of claims you make. Claims cost them money, not only because they need to pay you but also because of the administration costs associated with processing a claim. They use deductibles to try to minimize the number of claims they need to process.
In general, those who have higher deductibles are considered to be safer because they are willing to personally accept most of the risk associated with owning a home. Insurance companies typically reward this decision by offering their customers lower monthly premiums.
Conversely, those who choose to have lower deductibles are essentially passing the risk that comes with being a homeowner to the insurance company. They are more likely to file claims and cost the company money, and the insurance company responds to this by charging higher monthly premiums.
As a result, when choosing your deductible, you must think of it as a process in which you are trying to manage short- and long-term risk, something we’ll discuss in greater detail in a moment.
The Different Types of Deductibles
There are three different types of deductibles from which you can choose. They all work the same way, meaning they are what you must pay before an insurance company covers you, but there are a few different variations.
The three different types of deductibles are:
How Your Deductible Affects Your Rate
We mentioned briefly how insurance companies adjust your premiums based on the amount of risk you are willing to assume, i.e. they reward those who take higher deductibles with lower premiums and ‘punish’ those who want lower deductibles with higher premiums.
To give you an idea of how this works, here’s a snapshot of the average prices of policies with deductibles ranging from $500 to $2,500 in three different cities around the country. For the sake of consistency, the policies cover a $200,000 dwelling and $100,000 in liability.
Data retrieved from Insurance.com, which allows you to check average monthly rates for different policies in any ZIP code in the country.
Using these numbers above, we calculated the average savings between similar policies but different deductibles ($500 vs. $2,500) to be $292 per month, which translates to more than $3,000 per year.
Of course, that $3,000 savings could be offset by the costs you need to absorb should something happen to your home. But think of it this way:
- If something happens to your home one year after you buy it and the cost of the repairs is $7,000. With a policy that has a $500 deductible, you would only need to pay $500 towards the claim. But over the course of the year, you paid $3,000 more in premiums, meaning you paid a total of $3,500 towards the coverage.
- If you had a $2,500 deductible and had to make a $7,000 claim, you would only pay $2,500, which is $1,000 less than if you went with the low deductible plan. And if you go longer than a year before making a claim, the savings would be even more.
Based on this example, it might seem like a no-brainer to always choose a high deductible plan. But things aren’t this simple. There are more factors to consider, such as your short-term liquidity, which we will now discuss in more detail.
Factors You Should Consider When Choosing a Deductibles
The most important thing you need to keep in mind when choosing the deductible for your homeowners insurance is your financial situation. As mentioned, your choice of deductible is all about balancing your short- and long-term risks and costs.
But your financial situation factors in because, as you can see above, the size of the deductible you choose will have a direct impact on how much you pay in premiums and how much your insurance policy costs you in the long-term.
But there are other things to consider as well. Here’s a breakdown of all the important factors:
Your Ability to Cover Short-Term Costs
In a perfect world, we would all have a couple of thousand dollars sitting in an account somewhere that we can use in the event of an emergency. It would be there in case your car breaks down, a family member gets in trouble, you miscalculate your taxes, etc.
However, for many of us, this simply isn’t the case, and for those who find themselves in this situation, choosing a high deductible in favor of lower monthly rates exposes you to considerable risk.
This is because you need to be ready, at all times, to cover your deductible in full. So, if your deductible is $2,500, you need to have that money somewhere ready to spend in the event something happens to the house. If you don’t and something does happen, you’ll be unable to make the necessary repairs. This can have serious consequences later on since the insurance company can inspect your house at any time, and if they think the house is riskier because you didn’t fix it, you could lose your insurance. If this happens, the mortgage lender gets involved and things can really get messy.
So, when choosing a deductible, think long and hard about how much of these costs you can absorb at a moment’s notice.
Another important concern is liquidity. You may have this money saved up somewhere, but if it’s locked up in a protected investment (often a smart move), you won’t be able to access it when you need it.
Of course, how much you can and will have to spend on your own is entirely personal. For some, a $2,000 deductible isn’t much whereas for others that would be crippling.
And while it’s true you end up paying more in the long-term with a low deductible plan, it’s also true that it’s easier for some people to come up with a few hundred bucks extra in a month versus a few extra thousand in a pinch.
Your Ability to Pay Premiums
How much can you afford to spend on homeowners insurance? High-deductible plans obviously come with lower premiums, and this can lower the overall cost of your premium, but the risk comes back to you in the form of greater responsibility when you need to make a claim.
As a result, you need to carefully consider how much you can pay per month, and you also need to consider your money situation. For example, paying an extra $100 per month for a low-deductible policy might be easier for you than trying to keep a couple of thousand dollars in the bank in the event something happens.
On the other hand, if you have the money to cover a high deductible, then it actually makes a ton of sense to go with a high-deductible plan as you will pay lower premiums over the course of the policy and also deal with smaller claims on your own, something that will prevent more claims and the higher premiums they bring (more to come on this later).
Another thing to consider is the amount of risk that’s inherent with your property. In areas where weather and theft aren’t much of a concern, you can probably get away with a high-deductible plan even if you can’t afford that deductible right now. This is because the low risk your property poses will likely prevent you from having to make a claim, in which case the size of your deductible doesn’t really matter.
However, if you live in a high-risk area, such as one where hurricanes or other strong weather are common, then going with a high deductible is only smart if you’re sure you can afford it. And if you’re not sure, then it’s probably smarter to eat the higher monthly costs of a low-deductible plan so that you won’t get caught in a difficult situation when an emergency does happen.
But it’s worth mentioning that this approach is also quite risky as you’re increasing the chances of making a claim, which will drive your premiums up no matter what your deductible is. Yet if you feel taking on a high deductible is too risky, then you’d be wise to go for something that will truly cover you in the event something does occur.
Insurance companies use deductibles mainly to prevent you from having to file a claim. This is to the benefit of both parties, because claims cost the insurance company money, and filing them will cause your premiums to go up.
So, if you’ve had to make a lot of claims in the past and are experiencing higher premiums as a result, it might be a good idea to go with a higher deductible as this will both reduce the amount you need to pay in a month while also discouraging your from making more claims and driving your premiums up even higher.
At first, taking a larger deductible to save on your premiums might seem risky, but it’s a smart idea to raise your threshold (if you can) so that you can stop making claims. This is because the more claims you make, the more expensive your premiums, and the savings you get by not having to cover smaller losses on your own eventually disappear.
To give you an idea, here’s the average rate of increase in premiums as a result of making a claim for coverage:
The deductibles we have been discussing are specific to your overall homeowners insurance policy. They come into effect when you make a standard claim on your insurance. It applies to things such as storm damage, theft, fire, mold, etc.
However, for your standard deductible to apply, your claim needs to fall under your standard coverage, which typically does not include earthquakes, hurricanes, and floods.
Insurance companies deal with these events separately because the risks they pose are not distributed equally amongst policyholders. In other words, premiums are determined by risk, and the insurance company’s like to spread out risk as much as possible.
In this sense, you can think about your insurance premiums as a contribution to a large investment pool. You give your money to the insurance company and they take it, along with the rest of the money they collect, to invest it. But when you need it, they cover you.
However, the riskier you are as an individual, the more risk you pose to the group as a whole; if you need to make claims over and over again, the rest of the group needs to cover you, and this could cause premiums to rise for everyone.
In a country such as the United States, where some places are at high risk of severe weather such as earthquakes and floods and others are not, grouping everyone together and adjusting rates according to the risk posed by all members would be rather unfair. Someone in quiet, calm Idaho would end up paying higher insurance because someone in Florida faces a higher risk of having their home destroyed in a hurricane.
So, to prevent this from happening, insurance companies often add separate endorsements to your insurance policy that cover you for these extreme circumstances, which obviously means you pay more. And because these events pose high risks for the insurance companies, they often come with their own deductibles.
Here is a bit more information on how deductibles work for these types of coverage:
It’s possible the agent you are working with to buy your homeowners insurance might try to sell you an earthquake endorsement, but you really only need this in areas where earthquakes are a real and present danger. Areas such as California, which lies across the immense San Andreas Fault, for example, are good places to have earthquake insurance.
However, the deductibles associated with earthquake insurance are typically percentages. And it’s also quite common for you to have separate deductibles for structures and personal property.
Earthquake deductibles for your structure usually range between 5 and 20 percent. But if you live in an area where earthquakes are a real threat, it’s possible the insurance company may force you to take a deductible of at least 10 percent.
For these deductibles, choose wisely. Going for a higher deductible will obviously save you on premiums, but if an earthquake destroys your $200,000 home and you have a 20 percent deductible, you would be expected to pay $40,000 out of pocket to rebuild your home. A five percent deductible would mean you pay just $10,000. But you may end up paying more in the long-term due to the higher premiums such a policy would command.
Again, the best thing to do is to look at your financial situation and compare it to the risk involved. Earthquakes in certain areas are certainly more likely, but a home-destroying quake is still rather unlikely. Instead, it might be better to prepare for an event that doesn’t destroy your home but rather damages it. This would reduce the size of your claim and make it easier for you to handle a higher deductible. Also, know that earthquake insurance, while potentially useful, is usually not required. In most cases, not even lenders will insist you have it.
If you do opt for earthquake insurance, remember when shopping that personal property deductibles for earthquake insurance typically come in the form of percentages, but there is also usually a limit to the amount of property insured. If you want to raise that limit, you will need to pay more. For personal property, it’s usually better to go for a higher deductible since it may not be necessary for you to make a claim to replace damaged stuff, which means paying a lower deductible will reduce your long-term costs.
Hurricane and Wind/Hail Deductibles
Depending on your policy, damage from wind/hail might be included in your standard deductible. But if you opt for additional coverage, you may need to accept a different deductible for damage caused by this type of weather. They are most often a percentage.
Hurricanes are treated somewhat similarly as earthquakes in that there are special policies and deductibles used to cover the damage they cause. In most places, the deductible is a percentage, with the average being between 1 and 5 percent.
When choosing a hurricane deductible, use the same process as you did for choosing your overall homeowners deductible. Go for a higher one if you have the cash to cover basic repairs and don’t see hurricane damage as a huge risk, but got for a lower one if you live in a hurricane-prone area and wouldn’t be able to come up with the thousands of dollars needed to repair your home from a storm.
In total, there are 19 states that have special hurricane insurance policies and deductibles. They are:
- New Jersey
- New York
- North Carolina
- Rhode Island
Obviously, some of these states are at higher risk than others (Florida versus Pennsylvania, for example), and rates and deductibles will reflect this.
The last special type of insurance and deductible you need to choose deals with floods. Floods are not covered by most standard homeowners insurance and flood insurance is really only necessary in low-lying areas near rivers, coastal regions, and areas where hurricanes are a threat.
Flood deductibles range from $1,000 to $10,000 and they work in much the same way as the other deductibles discussed here. If you live in a flood-prone area, it would be a good idea to choose a deductible similar to your standard one. This is because the damage caused to your home by flooding will be covered by your flood insurance, but you must be ready to pay the deductible. And if flooding is a real risk, it doesn’t make sense to say, “I’m ready to pay $2,500 towards damage to my home from a fire but only $1,000 for a flood.”
In the end, your responsibility will be the same, so figure out which deductible makes the most sense for you and then choose a flood deductible that is the same or similar.
Choosing the right homeowners insurance deductible is not an exact science because we’re dealing in the realm of risk. This means there is no one formula for determining the right deductible for you. Instead, you need to consider your options and shop around, and you also need to figure out what you’re capable of handling financially.
An insurance agent might be able to point you in the right direction, but it’s best if you have an idea of what will work for you before starting to shop. Use what you’ve learned here to get an idea of what you might need, and then see what’s out there. Be patient. Be cautious. You will surely find a policy that works for you.