How Do Deductibles Work? Understanding Insurance Deductibles

If you’ve ever purchased insurance (and we’re guessing you have), you’ve undoubtedly seen the word “deductible.” It’s part of most insurance packages and it affects myriad factors within your insurance coverage, including your monthly premium, your level of coverage and much more. But what is an insurance deductible, and how do deductibles work? We’ll explore in the article below.

What Is an Insurance Deductible?

An insurance deductible is the amount of money you must pay for your out-of-pocket costs before your insurance coverage kicks in. In other words, it's your portion of the cost if you need to file a claim.

When you're setting up an insurance policy — whether it's for health insurance, auto insurance, homeowners insurance or other types of coverage — you typically get to choose your deductible amount.

Something to keep in mind: there's typically an inverse ratio between cost of deductible and your premium. In other words, the higher your deductible, the lower your monthly premium payment. But there's a downside, as you'll have to pay more out of pocket if you need to file a claim. Conversely, a lower deductible means higher monthly premiums, but there’s less to pay when you actually need to use your insurance.

How Does a Deductible Work?

While the idea behind deductibles across types of insurance is the same — they’re the amount you pay out-of-pocket before your coverage begins — they work a bit differently depending on the insurance policy you have.

For example, with auto insurance, you'll likely have separate deductibles for collision and comprehensive coverage. So, let’s say you have a $500 deductible for collision coverage and a $250 deductible for comprehensive coverage. If you get into an accident, you'd have to pay the $500 deductible toward repair costs before insurance covers the rest. But if your car is damaged by hail (which is just one situation covered typically by comprehensive insurance), you’d have to pay the $250 comprehensive deductible amount.

Conversely, homeowners insurance deductibles typically apply to the entire policy. Therefore, if you need to file a claim for damage from a fire, for instance, you pay the deductible first and then the insurance kicks in to cover remaining approved costs. Also, homeowners insurance costs are set by either a fixed dollar amount or a percentage of the insured value of a home.

• Deductibles are the out-of-pocket costs you pay before your insurance policy covers a portion — or all — of the remaining costs. So, if you have a $1,000 auto insurance deductible, that means you’re responsible for up to $1,000 on a claim. Once you hit that $1,000 threshold, your insurance policy takes over and your insurance company pays the remainder.

Higher-Deductible Vs. Lower-Deductible Insurance Policies

It can be comforting to have a lower deductible — that means you have to pay less money if you ever need to use your insurance. However, to get a lower deductible, you must pay more every month when you write your check for your monthly premium.

Similarly, a higher deductible means you have to pay more out of your own pocket before the insurance company covers the rest if you need to use your insurance. But it also means you pay less every month for the insurance itself, so you save money on those monthly bills.

So, it can be difficult to determine which is the right option for you. Which way should you go? Read on to find out!

How to Choose Your Deductible Amount

Given that your deductible amount can vary, you should take several differing factors into account when you decide how much you want to pay. Here are some of the key things to consider:

• Determine how much coverage you need. To figure out the right amount of insurance coverage for you and your conditions, start by adding all the money you have as well as the value of your belongings. That combination produces your assets. Then add up all the money you owe — those are your debts and liabilities. You should get enough insurance to cover the gap between your assets and liabilities.
• Consider the monthly insurance premium payment you can afford. According to conventional wisdom, you shouldn’t spend more than 10% of your total income on life, health, auto and other insurance policies. So, to determine the right level of insurance premium, you should calculate your monthly income after taxes and essential expenses (including housing, food and transportation), then determine an affordable premium amount that fits comfortably within your remaining disposable income.
• Be certain you can cover the deductible amount. It’s critical that you have money to pay your deductible, so it makes sense to create a savings account just for the funds that will eventually cover that amount. You can also adjust your budget to allocate money each month toward an "insurance deductible" fund until you have the full deductible amount saved.

Deductibles for Different Types of Insurance

Modern life is complicated, and that means we need different kinds of insurance for different situations we encounter. Here are some of the most common types of insurance with deductibles, although there are others, as well.

Health Insurance

One critical element of health insurance — which covers your health care costs — is that deductibles are assessed annually, not per claim. Also, paying the deductible doesn't eliminate all of your out-of-pocket costs — you will still owe coinsurance until hitting the out-of-pocket maximum. (Coinsurance, or a copay, is the amount that your insurance doesn’t cover for a medical cost. It is typically assessed as a percentage of the overall cost.)

After you’ve met your annual deductible amount, your health insurance will start sharing more of the costs for doctor visits and medical procedures — but not always all. Let’s use an example: say your coinsurance rate is 20%. Once you've paid the full deductible, you'll be responsible for 20% of any future medical bills for that year and the insurance company will cover the remaining 80% of those bills.

Auto Insurance

There are several different types of auto insurance — including liability, collision and comprehensive  — so it only stands to reason that there are different types of deductibles. Most states require you to have liability insurance, which covers the other driver's medical bills and repairs if you cause an accident. Collision insurance pays to fix or replace your own vehicle after an accident, while comprehensive insurance covers car damages from non-collision incidents like vandalism, theft or natural disasters. 

As you might expect, it can make sense to choose different deductibles for different coverages. For example, you might choose $1,000 deductible for liability but $500 deductibles for comprehensive and collision based on your reasonable analysis of the odds. As with all higher deductibles, they offer the opportunity to lower your premiums, but they also increase your out-of-pocket costs if you have a claim.

Homeowners Insurance

With homeowners insurance, your deductible is the amount you must pay out-of-pocket toward a claim before your insurance coverage kicks in. Deductibles apply per individual claim not as an annual cost, so if you have a $1,000 deductible and $15,000 in covered damages from a house fire, you pay the first $1,000 while your insurer covers the remaining $14,000.

The same situation applies if you have, say, water damage that same year — you will pay the $1,000 deductible for that claim, as well.

Renters Insurance

With renters insurance, the deductible applies to your personal belongings that have been damaged, destroyed or stolen. Similar to homeowners insurance, your out-of-pocket costs apply pay per claim rather than an annual cost. For example, if you have a $500 deductible and file a $3,000 claim for the costs of a robbery, you'd pay the first $500 while your insurer covers the remaining $2,500 after the deductible.

The main difference between renters and homeowners insurance is that the former doesn't include coverage for the physical rental property itself — that falls on the landlord's insurance policy for incidents like fires or storms.

Insurance Deductible FAQs

In the course of working with deductibles, questions are bound to arise. Here are some of the more common ones:

How do I meet a deductible?

A smart way to ensure you can meet your deductibles is to set aside money in a savings account for just this expense. For example, if your total annual deductibles equal $2,000, you could budget $166 per month into a savings account. That way, if you need to pay the deductible, you have the money there, at the ready. (And if you don’t use the money, you can invest it and look at it as a win-win down the road!)

Are insurance premiums and deductibles the same?

No, the insurance premium is the amount you pay monthly for your insurance coverage. The deductible is the out-of-pocket cost you pay before the insurance coverage kicks in.

Is it better to have a low deductible or a high deductible?

In order to determine whether it’s better to have a low or high deductible, you should first examine your financial situation and how much risk you're willing to take on. A low deductible means you'll pay more in premiums each month, but you’ll pay less out-of-pocket if you need to use your insurance. With a high deductible, you'll have lower monthly premiums but higher upfront costs if you require expensive treatment.

Let’s look at a health care example: Generally, a low deductible makes sense if you anticipate major medical expenses or have a chronic condition, while a high deductible can work well for healthy individuals willing to take on more potential costs in exchange for lower premiums.

What other types of insurance deductibles are there?

There are many other types of insurance, and they all come with their own types of deductibles. They include:

• Travel insurance: This insurance provides coverage for vacation cancellations, medical emergencies, lost luggage and other travel disruptions. A deductible is the out-of-pocket amount you agree to pay toward a claim before the travel insurance coverage kicks in.
• Pet insurance: This coverage helps allay veterinary costs for your pet if they get sick or injured. In this instance, you typically pay a monthly premium as well as an annual deductible amount. Then, when you take your pet to the vet, you pay the bill upfront but can submit a claim to get reimbursed for some of the covered costs after you’ve met your deductible.
• Long-term care insurance: This type of insurance covers occupational, speech, physical and rehabilitation therapy. Long-term care insurance policies typically include a deductible period, which is the amount of time you must pay for services out-of-pocket before the policy benefits begin. For example, a policy may have a 90-day deductible, meaning you would need to cover the first 90 days of care before the insurance kicks in.

How can I lower my out-of-pocket costs?

One way to reduce your out-of-pocket expenses is to choose a plan with a higher premium but lower deductible and coinsurance, and an out-of-pocket maximum policy. This will require higher monthly payments but will eventually have lower out-of-pocket costs. You can also put money into tax-advantaged accounts like a Health Savings Account (HSA) or Flexible Spending Account (FSA), which can help cover deductibles and other qualified medical costs.

What if the claim is less than my deductible?

If you need to file a claim and the estimate ends up being less than your insurance deductible, it may well be best not to file a claim at all. Why? For starters, there's no financial benefit to filing a claim if you aren’t going to use the benefits. Also, it shows up on your record, which can lead to higher premiums down the road. (This might be the case even if your insurer didn't cover any charges.)

If you realize the damages or expenses are less than the deductible, you can cancel a claim.

The Bottom Line

Deductibles are one of the many elements that make insurance complicated, but they’re not impossible to understand. It just takes time and some effort to understand how deductibles work with different types of insurance. To gain mastery over your financial life, download the Rocket Money℠ app for help tracking your spending, creating a budget and learning other ways to determine the size of deductible you can afford.