Your homeowners insurance covers not only your house but other buildings on the lot, such as a separate garage or a guest house out back. If you're renting out the guest house -- or the basement, or the attic -- regular homeowners insurance falls short in a lot of ways. The solution isn't to take out a separate policy but to take out one policy with broader coverage.
If you use the "mother-in-law quarters" to give your actual mother-in-law, or any other relative, a place to live, insurance isn't an issue. Your policy covers relatives who live with you, just as it does your spouse and kids. You might need extra insurance if your in-law has valuable property, but you can take care of that by increasing your coverage. There's no need to change your policy otherwise to protect yourself or your relatives.
When you rent out part of your property to a non-relative, your insurer takes a tougher view. Renting to a non-relative for a couple of nights isn't usually an issue, but if you've got a steady business going, your insurer can refuse damage claims relating to mother-in-law quarters. Even if you increase your coverage, your policy doesn't cover tenant possessions. If he wants to protect his property, he needs to take out a renters insurance policy of his own.
The simplest way to insure yourself is to pay extra for "unit rented to others" coverage. This addition to your regular policy covers property damage and liability related to your rental. If you have enough assets to be worth suing, it might be worthwhile paying $200 to $300 extra a year to get even more liability coverage. That protects you if, say, the roof falls in on your tenant and she sues you.
Whether you have a tenant moving in or just an in-law, a little pre-emptive work can save on insurance down the road. Screen tenants carefully: for example, if the tenant is living in or next to your home, you don't want to rent to a firebug. If you're hosting a relative covered by your policy, find out whether she has a dog: your insurer could cancel your coverage if, say, the company discovers it's now insuring a dog with a history of biting people.
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