Understanding Lender-Required Flood Insurance

"Just a few inches of water from a flood can cause tens of thousands of dollars in damage," according to the National Flood Insurance Program. This fact sums up why mortgage lenders sometimes require borrowers to get flood insurance. When property values decline significantly, homeowners facing possible foreclosure are often eager to avoid these additional expenses and leave the problem with the lender.

However, real estate agents and mortgage lenders often don't tell customers about flood insurance requirements until a property is already in escrow. Homeowners are also unaware that many areas that do not immediately appear to be at high risk of flooding are actually rated as high risk by the Federal Emergency Management Agency (FEMA). If you've found yourself in this situation or you don't want to be caught off guard, this article will help you by demystifying lender-required flood insurance. (Here's how to read one of the most important documents you own: Understand Your Insurance Contract.)

Homeowners insurance policies (also called hazard insurance) do not cover flooding - only a separate insurance product can protect against flood damage. Flood insurance is usually optional for mortgaged homeowners in what are normally considered low-risk flood areas. It may even be optional for mortgaged homeowners in high-risk flood areas, depending on the mortgage product. However, homeowners who take out a mortgage from a lender that is federally regulated or insured (such as an FHA mortgage) and buy a home in a high-risk flood zone (also known as a Special Flood Hazard Area) will be required to buy flood insurance. In most cases, the homeowner will have to pay for flood insurance every year until the mortgage is paid off.

When someone takes out a mortgage, the home serves as collateral if the borrower stops making mortgage payments. When a property is financed, the lender often has a greater financial stake in the property than the borrower. If one of the lender's assets is damaged by flood waters and the borrower abandons the home and stops making mortgage payments, the lender is caught in a losing position. To eliminate this risk, many lenders require the homeowner to purchase flood insurance. (Some things shouldn't be left to chance. Find out where you need coverage. Check out 5 Insurance Policies Everyone Should Have.)

The homeowner is not likely to walk away from a damaged home when it can be repaired at minimal cost. Flood insurance will provide money to repair or even rebuild a home if it is damaged or destroyed by flooding. The homeowner will keep the home and keep making mortgage payments. If the homeowner has to file a claim, he or she will only be responsible for paying the deductible. If the homeowner cannot pay the deductible, which may be as high as $5,000, there is still some risk that the homeowner could walk away. Also, since flood insurance maxes out at $250,000, as we'll discuss later, the owner might also be tempted to walk away from a property that will cost significantly more to repair or rebuild.

Flood insurance works just like other insurance products. The insured - the homeowner - pays an annual premium based on the property's flood risk and the deductible he or she chooses. If the property is damaged or destroyed by flooding, the homeowner receives cash for the amount of money required to repair the damage, up to the policy limit.

The homeowner must secure the flood insurance policy before closing on a property and renew it every year to cover the principal balance on the loan. The lender will usually collect flood insurance payments along with the monthly mortgage payment, hold the funds in an escrow account, and pay the entire premium to the insurance company once a year (similar to how property taxes and hazard insurance are handled). Thus, once the homeowner secures the initial policy, no further action may be needed aside from making monthly mortgage payments. Separate coverage of up to $100,000 for personal belongings is also available.

You can find out about the flood risk of any property at FloodSmart.gov. If the website says the property is in a high-risk area, flood insurance will likely be required. The final decision depends on flood insurance rate maps and an official flood zone hazard determination. You can see the maps yourself at FEMA.gov. You should also ask your lender about its flood insurance requirements.

In some neighborhoods or even entire cities, it may be difficult to find a home that is not in a high-risk flood area. In other regions, you can avoid the need to carry flood insurance entirely. (Use these simple ideas to save money and get better coverage for your house. To learn more, see Insurance Tips For Homeowners.)

The National Flood Insurance Program (NFIP), managed by FEMA, offers flood insurance to homeowners in communities that participate in the program. The program requires participating communities to "adopt and enforce ordinances that meet or exceed FEMA requirements to reduce the risk of flooding." This program also offers a small discount on flood insurance based on the steps communities take to mitigate flood risks.

The actual insurance policies are issued by private insurance companies, not by FEMA. You can find a participating insurance company at the FEMA website. Better yet, ask friends, family and co-workers in your town for recommendations.

The cost to insure a property against flood damage is determined by risk associated factors such as the year of building construction, the number of floors, level of flood risk and the amount of coverage required by the lender. This amount should be based on the cost to rebuild, which can be obtained from your homeowner's insurance company.

The price to insure a property with a particular deductible and particular amount of coverage will be the same no matter who you chose as your insurer because flood insurance premiums are government regulated. However, you do have some control over the cost of your policy because you can choose your deductible amount.

To find out how much flood insurance will cost for your residence specifically, complete the flood risk profile on the FEMA website and contact one of the participating insurance agents listed. The website only gives an approximate range of possible coverage costs. An insurance agent can give you an accurate quote. You can still get a quote even if you are just looking at the property and don't have it under contract. In general, expect to pay at least a few hundred dollars for flood insurance.

The maximum insurance amount allowed by law is $250,000 for the structure. Contents coverage is optional - it is not required by the lender - but it costs extra (and is limited to $100,000).

According to FEMA, the following items are considered part of the building's structure:

• The insured building and its foundation
• The electrical and plumbing systems
• Central air conditioning equipment, furnaces, and water heaters
• Refrigerators, cooking stoves and built-in appliances such as dishwashers
• Permanently installed carpeting over an unfinished floor
• Permanently installed paneling, wallboard, bookcases, and cabinets
• Window blinds
• Detached garages up to 10% of building property coverage (detached buildings other than garages require a separate building property policy)
• Debris removal

As specified by FEMA, lots of important and expensive things are not covered by flood insurance. You'll have to purchase additional personal property coverage if you are worried about the cost of replacing the following items:

• Personal belongings such as clothing, furniture, and electronic equipment
• Curtains
• Portable and window air conditioners
• Portable microwave ovens and portable dishwashers
• Carpets not included in building coverage (see above)
• Clothes washers and dryers
• Food freezers and the food in them
• Certain valuable items such as original artwork and furs (up to $2,500)

Additionally, neither building nor personal property flood insurance will cover the following:

• Damage caused by moisture, mildew or mold that could have been avoided by the property owner
• Currency, precious metals and valuable papers such as stock certificates
• Property and belongings outside of a building such as trees, plants, wells, septic systems, walks, decks, patios, fences, seawalls, hot tubs, and swimming pools
• Living expenses such as temporary housing
• Financial losses caused by business interruption or loss of use of insured property
• Most self-propelled vehicles such as cars, including their parts

Flood insurance is expensive and like other more common forms of insurance can make homeownership less affordable or even unaffordable for some people. Calculate whether you will be able to afford flood insurance for as long as you are required to have it before you commit to a property. If your flood insurance policy costs $1,000 a year and you take 30 years to pay your mortgage, that's an additional $30,000 long-term cost to own that home.

Some flood insurance companies will try to make you buy insurance for the maximum of $250,000 even if the lender doesn't require this much coverage. If the principal amount of a loan is only $200,000 the extra coverage is not necessary. Look at the replacement value for your house as determined by your homeowners' insurance company. This is full the amount you need to purchase insurance for. The insurance only needs to cover the value of the physical structure, not the land.

If you're thinking about refinancing and you are not required to have flood insurance under your existing mortgage, see if your flood designation has changed. You may now be in a high-risk flood zone even if you weren't before. It may not be worth it to refinance when you add the new cost of flood insurance.

Finally, the maximum allowed coverage of $250,000 may not be sufficient to rebuild some properties. If your homeowners' insurance company says it will cost more than $250,000 to rebuild your property in the event of a total loss, be aware of the risk you are still subject to even with flood insurance coverage.

There are several options for avoiding lender-required flood insurance, though they are not ideal for everyone, especially those living in high-risk areas.

Research before you buy - find properties that aren't located in flood-prone zones.

Have a survey done (for around $1,500) to see if your specific property is elevated enough to not be in the flood area even if your community generally is. You may be able to get an exemption if you can prove that your property is not at high risk.

Organize your community and work with local government to do things to mitigate flood risk to the point where the area is no longer in a high-risk area.

Having to buy flood insurance shouldn't be an ugly surprise when you're purchasing or refinancing a house. Educating yourself now can help you understand when lenders require flood insurance, how to reduce its cost, or in some cases, even how to avoid it altogether. (Discover everything new homeowners need to know before they sign on the dotted line. Refer to The Beginner's Guide to Homeowners Insurance.)