Sold a property and owner financed. Is new owner under insured?

Question

We just closed last week.  There was a section in the mortgage that states that the owner will have a policy that covers the "full insurable value" and a lot of other legal jargon.  The gist of the paragraph is that he needs to have enough insurance, and if I'm not okay with it, I can pay the difference and add that onto his loan at the highest interest rate allowed by law.

A couple days after closing they sent over the evidence of insurance document and the policy is covered for 275K less than the amount I loaned him.  I have heard mortgage companies requiring the borrower to be insured up to the amount of the loan, but I don't know what this looks like in practice.

Is he under insured? I'm new to owner financing and I may be misunderstanding insurance policies from a lender's standpoint. I wanted to consult you guys before speaking with an attorney. Any advice is greatly appreciated. Thanks!

John Mocker · Answer

John,

Often there is confusion by Mortgagees on what is being covered by a Homeowners policy.  You sold him a property that includes Land & Building.  Homeowners Insurance covers the Building, Contents, Additional structures, Liability, etc. but not the land.  What the policy should be covering is the Replacement Cost (cost to rebuild with like kind and quality) the existing building.   If the building could be rebuilt for the $275,000 then you would be in the same place after the loss and the rebuilding as you are now.  If the building can not be rebuilt for the $275,000 then the limit needs to be adjusted.   Your old policy may give an indication of what you were insuring it for.  Your agent may also be able to run the replacement cost estimate in several companies to see how they compare.  The best way to be sure of limit is to check with a builder to see what they would charge to rebuild the house.

In Connecticut the high land values often cause this confusion.  Because Banks were trying to require limits (based on loan values) that exceeded the cost to rebuild, the State Insurance dept banned that practice.

Hope that helps

John Hammond · Answer

So if there is an event that renders the land worthless I would lose all of the money I loaned?

For example the building and land wash into the ocean during a landslide.  The insurance will pay to rebuild the house, but the land will be underwater from here on out.  The borrower stops paying and the lender forecloses.  There is no possibility of building.  No one will buy the property, and the lender is out the money they loaned.

The lender would essentially be the only one losing money in this scenario.  If this is the case, I'm surprised banks would ever lend on cliff-side mansions in California.  Surely there has to be a system in place that they could get their money back?

Sorry if these concepts are rudimentary.  I'm new to all of this so bear with me if there is something obvious that I'm unaware of.