You’ve almost certainly heard the word "deductible" before. If you're new to purchasing your own insurance, however, you might not fully understand what it means and how it can affect the cost of your insurance coverage. Or you may not realize that there are different kinds of deductible and not all are made equal.

Deductibles are common in auto, homeowner's, renter's, and health insurance policies. In this article, we'll discuss different types of deductibles, how they can affect your coverage and its cost, and give some recommendations for setting your deductible.

Deductibles Defined

Let's start with the obvious question: just what is a deductible?

A deductible is in a sense a form of self-insurance. If your property is damaged, you're involved in a car accident, or you need medical care, you are responsible for paying part of cost of the costs. That part you pay is the deductible. It is, in other words, deducted – subtracted – from the amount that the insurer pays.

When it comes to auto and home insurance, deductibles only apply to the property damage portion of the coverage. There will be no deductible on the liability coverage; it will always start with the first dollar of loss.

Why Deductibles Aren't So Bad

So, you buy insurance but because there's a deductible, you have to pay for part of the loss yourself. Are you just being cheated?

Not at all. Here's why.

Small claims are expensive for insurers to process. They need to send adjusters to investigate, take photographs, write reports, and follow all the standard procedure. When the claims are small, that process can cost more than the claim is worth. With deductibles, however, many small claims don't need to be investigated. If you have a $500 deductible on your automobile collision insurance and you find your car in the parking lot with a taillight broken by another driver, would you call your insurer to report the loss? No, you wouldn't, because a tail light costs less than $500. Instead of wasting the insurer's time (and your own), you simply fix it yourself.

By eliminating all that extra claim processing, deductibles can reduce the cost of insurance, sometimes by a lot. Also, insurers assume, and likely they are correct, that insureds will take better care of their property if they know that they will bear some of the cost of a loss.

The more potential paperwork and payouts you eliminate, the more affordable your insurance is. Simply put: higher deductibles mean lower premiums (for related advice, check out Top Twitter Feeds to Follow if You Want to Save on Insurance).

Types of Deductibles

If you already had a good grasp of deductibles, none of what we've covered so far has been news to you. But you may be surprised to find out that there are multiple types of deductibles.

Flat or Straight Deductible

This is the most common type of deductible. It's a fixed dollar amount that is applied whenever you file a claim.

For example, let's say your homeowner's insurance has $100,000 coverage for property damage with a $2,500 deductible. One night, when you are out of town, vandals throw rocks through your windows and do $4,000 worth of damage. You will be able to recover $1,500 from your insurer for this (4,000 - 2,500). A month later, a fire starts in your kitchen and does $35,000 worth of damage. You will be able to recover $32,500 for this loss (35,000 - 2,500).

Percentage Deductible

These are less common, and they're usually reserved for policies that cover losses that are likely to be catastrophic or total.

Earthquake coverage, when it is available, is often subject to a percentage deductible. If you insure your home for $300,000 against earthquake damage with a 15% deductible, and an earthquake later does $200,000 worth of damage to your home, you could recover $170,000 from the insurer ($200,000 less 15%, or $30,000, for the deductible).

Waiting Periods

These aren't always called "deductibles," but in some sense, they are.

If you buy flood insurance, for example, it might be subject to a waiting period before it takes effect (and even then, there are limits – learn about some of them in Water and Flood Insurance: 6 Things That Aren't Covered).

Split Deductible

If your policy has a split deductible, the deductible that will apply will depend on the kind of claim you file.

An example of this is found in some health insurance policies that have preferred provider networks. If you are treated by a healthcare provider who is in the network, your deductible will be lower than it would be if you acquired treatment from an out-of-network provider. Similarly, in some policies covering property damage, a flat deductible might apply to some losses, while a percentage deductible applies to others.

How Big Should Your Deductible Be?

Now that you know how all these different deductibles work, and why a deductible can work in your favor, you're probably wondering how high your deductible should be.

I'm sad to say that there is no magic number. It is partly an economic decision and partly a psychological one. In other words, you have to ask yourself how much risk you can afford and how much you are comfortable taking on.

With car insurance, age is an issue. If you are 55 and have a clean driving record, raising your collision deductible from $250 to $1,000 will make almost no difference. Why? Because the insurer figures that you are unlikely to be involved in a collision. But if you are a 20-year-old man, that places you in a high-risk group. And if your vehicle is worth less than something in the range of $5,000, you might consider doing without collision insurance after you see how much that insurance is going to cost you (learn about The Top 5 Factors That Affect Your Auto Insurance Premium).

One way to help you decide how big a deductible to get is to consider how long it would take you to save enough to pay that amount. If you are saving $500 every month, a $1,000 deductible – even a $2,500 deductible – is not so big when you consider how likely you are to file a claim. On the other hand, if you have no savings and spend almost everything you earn every month, a lower deductible might make sense (if you can afford it).

The same logic applies to homeowner’s, renter’s, and heath insurance policies. If you can afford to pay a large deductible and are not very likely to make a claim, a large deductible will most often save you money. If you cannot afford to pay a large deductible, or if you feel that you making a claim is at least somewhat likely, a smaller deductible might make sense.

Last but not least, there is a psychological factor at work: what level of deductible are you comfortable with? For that one, you'll need to do some soul searching. That's a question this article cannot answer.

Corridor Deductibles

We should briefly discuss one last type of deductible. I left it to the end because most people will never encounter it.

The corridor deductible (also known as a corridor self-insured retention, or corridor SIR) is something you might want to look into if you want to extend your primary coverage with an umbrella policy. The corridor SIR is a deductible between your primary policy and the umbrella policy that supplements it (find out Who Needs Umbrella Insurance).

How does it work?

If your primary coverage is for $1 million and you have an umbrella policy that provides an addition $10 million, one way to save on premiums is to slot a corridor deductible between these two coverages. Let's say your deductible is $500,000, that means once you have exhausted your $1 million of primary coverage, you will have to pay the $500,000 deductible before availing yourself to the umbrella policy's additional $10 million protection.

Adjust According to Your Needs

Deductibles allow you to adjust the kind of risk you take on and lets you get a premium rate you find manageable. Knowing how deductibles work, you can now make an informed decision about how you'll pay for your coverage: with higher premiums or with a bigger deductible.