Most home buyers are familiar with the concept of homeowners insurance. These policies cover hazards such as fires, pipes bursting, and more. But there's another important type of insurance you should know about -- title insurance. Here's what all home buyers should know about title insurance, and why it's such an important part of any real estate transaction.

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What is title insurance?

Before a real estate transaction can be finalized, the title from the property must pass from the buyer to the seller. And the title needs to be clear, meaning that it shows that the seller is the undisputed legal property owner.

As part of the closing process, a title company must conduct a search to determine if a title is indeed clear. Title searches look for things like building code violations, liens on the property, and other issues.

Title insurance protects the insured against title issues that are uncovered after closing. It's an important part of a real estate transaction for anyone who will have a financial interest in the property after the transaction is finalized.

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What is a clear title?

Clear title means a property is free of any lien, encumbrance, or title defect that could cause dispute about legal ownership. Defects or liens such as a mortgage, unpaid property tax, municipal lien, code violation, discrepancy in legal description, or mispelled or mismatched owner names, among other issues, can cause questions over legal ownership. When there's a clear or good title, there are no legal defects, and the current property owner is evident and clear.

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Why do I need title insurance?

Title searches aren't perfect. It's not common for these thorough searches to miss something, but it does happen. And you need to be protected from others claiming ownership of your property months (or years) down the road.

Consider this scenario. You enter into a contract to buy a home, the title search comes back clear, and then you close on the property. A few months later, someone shows up claiming to be the prior owner's older sibling. They state that the property was left to them in a will and should never have been sold.

While situations like this aren't too common, it's extremely important to have title insurance in case they happen. Your title insurer will typically cover things like ownership disputes, document forgery, and restrictive covenants that were previously unknown. They can also protect you from unknown liens and judgments against the property, just to name a few title defect examples.

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How does title insurance work?

There are two main types of title insurance. Both are typically purchased by one party to a real estate transaction for the protection of another.

Lender's title insurance: Borrowers buy this type of title insurance to protect their mortgage lenders. Virtually every mortgage lender requires it. Since the lender typically takes the largest share of the financial risk in a home sale, it wants to know its investment is protected in the event of unforeseen title issues. If you're buying a home without a mortgage, you won't have to worry about paying for a lender's policy.

Owner's title insurance: This is designed to protect the buyer from title issues, and the expense is typically incurred by the seller. This is an optional, but very common, type of title insurance.

Title insurance isn't cheap. For an owner's title policy, the title insurance premium can easily exceed $1,000. But this can be a small expense compared with the cost of finding out someone else legally owns the property. Or compared to discovering years of back taxes that weren't found in the title search.

Typically, both title policy types are purchased during the course of a real estate transaction and will provide enough coverage to make sure neither the buyer or lender are financially harmed if a title issue is found after closing.

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What happens if I don't have title insurance?

If you use a home loan to purchase the property, your lender will have title insurance. This is true whether you're purchasing the property or refinancing it to get cash or to take advantage of lower refinance rates. (Check out our beginner's guide to home loans if you have more general questions about the mortgage process.)

But if the seller doesn't purchase owner's title insurance for you, it could be a costly mistake if issues are uncovered later on. For example, if it turns out that there's a $10,000 judgement against the property that the title search missed -- let's say that the previous owner never paid a contractor for work done, and the contractor sued -- the owner's title insurance would likely take care of the expense (if legitimate). But if you don't have title insurance, you could be forced to pay it out of your own pocket or risk losing the property to foreclosure.

In short, title issues after closing aren't common. However, real estate transactions involve large sums of money, and your mortgage payment is likely to be your biggest recurring expense. Check out our mortgage calculator to see what a home could cost you.

It's important to make sure you're protected with title insurance. If you're planning to buy a home, the best practice is to insist that the seller purchases title insurance from a reputable title insurance company for you. And be sure to verify that it's in place before you sign your closing documents.