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Have you taken a loan to buy your dream home? If so, you will be familiar with the process. One of the requirements that your lender would insist on, is for you to take an insurance policy on the home that you are planning to buy. The lender gives you an approval letter (or sanction letter as it is commonly called), which would stipulate that you should take out an insurance policy on the property that you purchase, for the full price that you paid for it.
What cover does a home insurance provide?
The lender would typically ask you to take a policy from an insurance company with whom they have a relationship, for the value of the property. This policy is then assigned to the lender, until the loan has been fully repaid and the mortgage over the property is removed. Now, if you read the details of the home insurance policy, you will find that it covers earthquake, fire, flooding and similar catastrophes. The fine print would probably say somewhere that in the event of one of those disasters occurring, you can claim the cost of rebuilding the flat or the house that you bought. However, this value would not be more than 20% to 25% of the cost of your home, whereas you have taken out a policy for 100% and have paid the premium for that full value. This percentage could vary from city to city, based on the property values prevailing in each city.
Essentially, a property can only be insured for the cost of reconstruction of the property (at the time of the claim) in the event that it has been destroyed by an earthquake, fire, cyclone or other such natural disaster.
How to calculate insurance amount while taking a home loan?
Let us look at an example. Suppose you bought a two-bedroom flat in Mumbai suburbs, for Rs 1 crore. You paid Rs 20 lakhs from your savings as a down payment and the bank is going to give you a home loan for the remaining Rs 80 lakhs. The bank pays your seller the Rs 80 lakhs and takes the title deeds to your property, which you then mortgage in their favour. Now for the insurance. You are required to take a policy for Rs 1 crore, which works out to approximately Rs 5,800 per annum, including GST @ 18%. Over a 15-year mortgage, the premium works out to Rs 87,000.
What would the premium be, if the policy was only for the reconstruction cost of your flat? If your two-bedroom flat was 1,000 sq ft and the cost of construction was Rs 2,500 per sq ft, the cost of reconstruction would total up to Rs 25 lakhs and the premium with GST would be Rs 1,450 per annum. Over 15 years, the premium would be Rs 21,750. So, you have been overcharged by Rs 65,250 over the life of your loan.
This means that you have paid a premium of at least four times of what you should have paid. The insurer has taken more premium than he should have taken and the lender is also complicit in this, since he gets a commission or referral fee on the premium that you have paid.
See also: Home insurance vs home loan insurance
What type of insurance should you take for a home loan?
Moreover, if you happen to live in a cooperative housing society in Mumbai, the society is required, by law, to insure the entire property, including the flat that you just bought. This means that you need not have taken out the insurance policy at all. All you would have to do is get a letter from the secretary or the chairman, saying that the property is insured for fire, earthquake, floods, etc.
In the absence of data, it is difficult to gauge the extent of prevalence of this practice of insuring the property for its entire worth, while taking a loan. However, this practice is more prevalent than one would think. The law says that a contract of insurance is one of ‘utmost good faith’ but in such instances, it may seem to be anything but that.
How can one avoid falling into this trap? The borrower should simply tell the lender that the sum insured should only cover the reconstruction cost of the property (which any insurance agent can provide) and that you will only take out a policy for that value. Tell them you would go to another lender, if they refuse.
Also check from the seller if the property is insured by the society or the builder. Tell the lender that you can get a confirmation from either of them that the building is insured. The lender may want the society or the builder to note their interest as a lender to you against the property and this can be arranged, as well.
(The writer is advisor, Aavishkaar Group.)