Rachael Green
When you buy homeowners insurance, you probably expect it to pay the full cost of any damage covered by the policy, minus any deductibles you're supposed to pay. But if you haven't followed the 80% rule (also known as the 80/20 rule), you might be in for an unpleasant surprise.
Used by most insurers, the 80% rule determines whether your insurance will cover claims you make in full. If your policy doesn't follow the rule, you may only receive a partial payout for any damage.
So, if you've never head of this rule, it's worth learning what it is, how it works, and how to tell when it might be time to update your home insurance policy to ensure you're fully covered before disaster strikes.
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What is the 80% rule in homeowner's insurance?
The 80% rule in home insurance dictates that in order to receive full coverage on a claim, homeowners must have coverage worth at least 80% of their home’s total replacement cost. The total replacement cost isn't the current market value of your home, but the estimated cost of rebuilding the house from the ground up.
If your coverage limit is less than 80% of the replacement cost, your insurance will only pay a portion of any claim you make, based on the coverage you do have.
To understand how that affects you, imagine this hypothetical scenario. Say the current replacement cost for your home is $600,000. To follow the rule, your policy would need a coverage limit of at least $480,000 (80% of the replacement cost).
But you haven't updated your home insurance in a while, so your policy only covers up to $450,000. That's only 75% of the actual replacement cost, and only 93.75% of the $480,000 minimum coverage limit according to the 80% rule.
If a hurricane rips through, flooding your basement, and a contractor estimates the repairs will cost $50,000, you'll make a claim for the damages. Instead of receiving the full $50,000, your insurance will only pay 93.75% of your claim, or $46,875. You'll be on the hook for the remaining $3,125. That would be on top of any deductible you need to pay.
At first glance, being stuck paying a few thousand more than you thought might not seem like the end of the world – especially when your insurance still covered over $45,000 worth of damages. But that money can add up over time, especially as the gap between the replacement cost and your coverage continues to widen with inflation.
How do you calculate total replacement cost?
“Replacement value is typically calculated by multiplying the average local per-foot rebuilding cost by the square footage of the house,” according to Demont Insurance.
As it can be complicated to calculate this total, most insurance companies estimate this value for you. However, here are the essential factors that go into calculating your total replacement cost, according to Horton Insurance Group.
- Square footage of your home
- Home renovations and improvements (e.g., changing flooring, appliances and fixtures; updating a roof; or installing new windows)
- Cost of replacing materials
- Labor costs in the event repairs are needed
- Value of interior and exterior components
It's important to regularly review your home's total replacement cost value and adjust your coverage limit as needed.
You can't really calculate the exact replacement cost yourself without knowing exactly what criteria your insurer uses or getting actual quotes from contractors to rebuild your house. However, you can note any upgrades or changes you've made since moving in and talk to your agent about how they might impact the replacement cost.
Use our tool below — powered by Bankrate — to compare home insurance rates today.
How to avoid being underinsured
One common way homeowner's end up falling below the 80% rule is by making upgrades and not notifying their insurance. Say you recently finished your basement, complete with flooring, insulation, drywall, and everything else needed to turn it into usable square footage.
If your insurance company doesn't know about the upgrade, the replacement cost is still going to be based on the assumption that the basement is unfinished. The same is true for other big ticket upgrades like replacing the HVAC, adding a pool, or building an addition that adds square footage to your home.
Even if you haven't made any major changes, you might still find yourself underinsured depending on how your coverage limit is calculated. In some policies, your limit might already be tied to the replacement cost, meaning your coverage adjusts each year to match the full replacement cost estimate.
However, other policies may calculate the coverage limit differently, such as using the actual cash value. This factors in depreciation of the materials through normal wear and tear.
So, as your home ages, your coverage limit might shrink rather than increase to keep up with inflation. While that might mean low premiums, it also means you won't get nearly a big enough payout if your home was destroyed.
It also means the amount you'd get for smaller repairs would shrink, too.
You don't want to over-insure, either
Falling below the 80% rule puts you at risk of paying more out of pocket for repairs. But increasing your coverage too much can be costly, too. If you try to come up with your own rough estimate of the replacement cost and increase your coverage accordingly, you might end up overpaying.
If you set your limit at $800,000, but the actual replacement cost is only $600,000, you're paying for $200,000 worth of coverage that you can't use. That's going to increase your premiums unnecessarily.
Similarly, some changes you've made to your home might have actually decreased the replacement cost. For example, if there was a pool in the backyard when you moved in but you've since had it removed, your replacement cost might still be including the estimated cost of replacing a pool you no longer have.
And keep in mind insurance pays close attention to risk as part of its underwriting process. By closing up the pool or replacing it, you reduce the risk of incidents occurring outside of your home, which could lower your premiums.
Furthermore, while coming up with a rough estimate on your own is useful for figuring out if your coverage might be too low, make sure to talk to your agent before you actually make any adjustments to your coverage. Talk to them about any upgrades or changes to your home that might impact the replacement cost. They can help you figure out if any coverage adjustments are needed.
Another option is to shop around for home insurance quotes. During the process, insurers will typically ask you for details about your home so they can come up with a replacement cost estimate. Compare the replacement cost given in the quote to your existing policy to see how they line up.
The bottom line
Knowing how the 80% rule works in homeowners insurance ensures you have enough coverage on hand to financially protect you in the event you need to file a claim.
Also, if you do make any home improvements like filling in a pool or adding an addition to your home, make sure to notify your insurance carrier so they can factor these changes into your home's replacement costs.
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