Replacement Cost vs. Actual Cash Value Explained
Will your insurance cover your next possible disaster?
Replacement Cost Vs. Actual Cash Value
Will your insurance cover your next possible disaster?
When comparing home insurance rates, be sure that you are receiving quotes for the exact same coverages and benefits. Be careful not to confuse a replacement cost policy with an actual cash value policy, as these are two completely different types of insurance policies. The following guide explains the difference between these two types of coverages and will help guide you towards making the right decision.
Replacement Cost
Replacement cost is the amount of money it would take to replace or rebuild your home or repair damages to your home using similar style and quality construction materials, without taking depreciation into consideration. Depreciation is the decrease in a home’s or property’s value since the time it was built or purchased due to its age or normal wear and tear.
Most insurance companies require homeowners to insure their homes for at least 80% of whatever the replacement cost value is. If the homeowner fails to cover their home for at least 80% of the replacement cost value, a penalty can be applied when partial losses occur.
For example, if it would cost $100,000 to replace your home and it is insured for $80,000 (80% of its replacement value), and a fire causes $50,000 worth of damage in your kitchen, your insurance company will pay the full $50,000.
On the other hand, if your $100,000 home is insured for only $65,000 (which is less than 80% of its replacement value), and a fire causes $50,000 worth of damage in your kitchen, your insurance company would only pay for part of the damage and you would be responsible for having to pay the remaining balance out of pocket.
So, how much will your insurance company pay and how much will you have to pay?
Your insurer would pay for the damage based on the following replacement cost formula:
The Amount of Insurance You Have = $65,000
= 81.25 %
The Amount of Insurance Needed (80%) = $80,000
Using the kitchen fire example above, your insurance company would pay only 81.25% of the $50,000 damage to your kitchen, which equals $40,625. That means you would be responsible for coming up with the remaining $9,375 needed to fix your kitchen – which is a whole lot more than it would have cost to insure your home for the minimum requirement of 80%.
As you can see from this example, keeping your home insured for at least the minimum requirement of 80% of replacement cost value is very important and can save you lots of money and trouble in the future. Different companies may have different requirements for replacement cost value, so be sure to check the requirements and rates for multiple companies.
Actual Cash Value
Most standard home insurance policies cover the contents of your home, such as your personal belongings, on an actual cash value basis. Actual cash value is the amount of money that it would take to replace or repair damage to something after considering depreciation.
For example, if a powerful storm causes damage to several items in your living room and your 5 year old television is destroyed, you would not get back the same amount of money that you originally paid for the television 5 years ago. Instead, the amount of money that you could expect to be paid back would be the actual cash value of the television today, after depreciation.
Many insurance companies offer an additional coverage option for you to insure your personal belongings at replacement cost value. Choosing this option will raise your rate slightly, but will also guarantee that you will have sufficient coverage to replace your personal items in the event of a loss.
Regardless of whether your home is insured on a replacement value basis or actual cash value basis, it is important that you keep track of your home’s current value and note any new construction or improvements you make. Home improvements that you make can affect the value of your home and you will need to update your insurance policy as well.
For example, upgrading your home’s heating or electrical systems, building a new addition such as a deck or porch, and yearly inflation all should increase the replacement cost of your home, while the actual cash value may decrease over time due to depreciation.
Compare insurance prices at least once a year to make sure your policy still provides adequate coverage and you are receiving the best price available.
