Why Slashing Your Homeowners Insurance Coverage to Save Money Is a Really Bad Idea

As if homeownership wasn't expensive enough, the rising cost of homeowners insurance has made things even worse for Americans. This is especially true for those living in coastal regions likely to be struck by hurricanes and those out west at risk of wildfire damage. These costly disasters can wipe out entire neighborhoods in one day, and insurers have been charging more accordingly.

Some homeowners, desperate for a way to cut costs, might consider reducing their homeowners insurance coverage to save on premiums. But this can have serious long-term consequences that could hurt homeowners' wallets more than high insurance rates.

Can you lower your homeowners insurance coverage limits?

First, let's talk about the feasibility of reducing homeowners insurance coverage. When a homeowner has a mortgage, lenders mandate how much coverage the homeowner must purchase. 

Mortgage lenders require homeowners to maintain coverage equal to the home's value. This is to protect their investment in the property. If the homeowner lacked adequate insurance and then a disaster destroyed the home, the lender would be out a lot of money. 

If a lender discovers that a homeowner lacks adequate insurance, it will send a notice to the homeowner demanding that the homeowner increase their insurance coverage. Failure to comply could result in the lender seizing the property. Realistically, most homeowners who want to save on premiums this way don't really have that option.

What happens if you drop your homeowners insurance coverage limits?

Dropping homeowners insurance coverage is problematic because it could leave homeowners without adequate funds to rebuild in the event of a claim. But things work a little differently than they do with auto insurance.

An auto insurer will pay up to the policy limits in the event of a claim and then leave the driver to cover the rest. But homeowners without adequate coverage could get even less help.

Homeowners insurance has what's known as the 80% rule. This says that if a homeowner fails to purchase coverage for at least 80% of the home's total replacement value, the homeowners insurance company only has to pay a proportionate amount of the damages.

For example, let's say a homeowner has a $500,000 home that suffers $100,000 of damages due to a natural disaster. The homeowner had $300,000 worth of coverage on the property. However, that's only 60% of the home's replacement value. So even though the $100,000 in damages is under the $300,000 policy limit, the insurer doesn't have to pay for the whole thing.

Instead, the insurer would look at how much coverage the homeowner purchased compared to what they should have had. In this case, 80% of the home's value would be $400,000 and they had $300,000. That's 75% of what they needed. This is also the percentage of the damages the insurer will pay.

Instead of getting the full $100,000 for the damages, the homeowner would only get $75,000. They'd need to find a way to cover the remaining $25,000 on their own. Oh, and they'd have their deductible to pay, too.

Better ways to reduce homeowners insurance premiums

The risks that come with reducing homeowners insurance coverage aren't worth it. Here are some better ways to shrink premiums:

• Shop around: Compare rates from several homeowners insurance companies to see which offers the best deals.
• Take advantage of discounts: Homeowners who have made changes, like replacing their roof, or redoing their home with fire-resistant materials, should seek out homeowners insurance companies who reward these behaviors.
• Raise the deductible: Raising the homeowners insurance deductible will reduce monthly premiums. However, this also leads to larger out-of-pocket costs in an accident.

Set aside time to compare all these options with several top companies before deciding which insurance provider to go with.