Actual Cash Value vs. Replacement Cost in Homeowners Insurance

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There are three options when it comes to calculating the amount of protection your renters or homeowners insurance will provide. The options are available through most home insurers (and most states) and are selected at the discretion of the policyholder. While replacement cost valuation is the most popular, it’s important to understand each option because they can result in different protection values and affect your premium differently.

Actual Cash Value (ACV)

The actual cash value in a homeowners insurance policy is based on the market value or the initial cost of your home and personal property with depreciation considered. Most standard homeowners insurance policies cover the replacement cost of your home's physical structure and the actual cash value of the insured’s personal property. An insurance policy with coverage based on actual cash value is the least expensive to purchase, since depreciation is considered and the claim payments are generally lower.

Definition of Actual Cash Value: Intial cost to buy or market value of item less depreciation for the number of years you had it.

Insurers tend to calculate depreciation differently. A common method for determining depreciation takes into account an expected lifetime of an item, then subtracts a percentage of value for each year since its purchase. For example, say you bought a television for $1,000 four years ago that is expected to last 10 years. The estimated straight-line depreciation calculation would be 1,000 / 10 x 4, which equals $400. This leaves the actual cash value of the television insured by your home policy to be $600 ($1,000 - $400). As you can see, this means that the insurance coverage for your personal belongings will typically decrease over the number of years you hold them.

Replacement Cost Coverage

Sometimes called “RCV,” the replacement cost for homeowners insurance is the amount of money it would take to replace your damaged or destroyed home with the exact same or a similar home in today's market. Some home insurance policies and endorsements also cover the replacement cost of personal property. This is generally the most recommended option, since it gets homeowners closest to their living situation before a covered peril occurred.

Definition of Replacement Cost Value: The replacement cost is usually calculated using the initial price tag paid for the items or the cost of physically building the home when it was purchased, regardless of any potential depreciation.

Remember, this is the value of the home or items, not the land it sits on. It's generally recommended that you get a contractor or appraiser to evaluate your house's replacement cost. They'll know how to price the cost of the building's construction materials (such as granite, windows, or doors), any unique or valuable upgrades in fixtures or added living space (porch, entertainment space, etc.), and come up with your house's fundamental value.

For a simple example, say you purchased a new home for $350,000. That price likely included the cost of the lot it was built on and the cost of constructing the dwelling. If the lot was priced at $50,000 you only need to insure the cost of the home, which would be $300,000. This assumes there is no market appreciation in the $350k figure.

Sometimes the replacement cost is paid in two installments. First, the insurer will pay either the actual cash value or half of the replacement cost. Then once repairs have been made and you can send documentation to the insurer, they will pay the remaining replacement cost.

Guaranteed or Extended Replacement Cost

This option offers the most protection out of the three, and the costliest out of the three option. It is essentially an expanded version of replacement cost described above. The guaranteed replacement cost option pays for the cost to rebuild your home exactly as it was before a peril, even if the cost exceeds the estimated value of the home. The primary purpose of the option is to protect the policyholder against sudden increases in materials or construction costs, which can occur when many claims in an area are made. This is a good option to consider if your budget allows for it, and you live in a region that is prone to natural disasters or weather patterns with a large scale.

Rather than a guaranteed replacement policy, some insurance companies offer an extended replacement policy. Instead of guaranteed cost coverage, the extended replacement option covers an additional 20% to 25% of the replacement value of the home.

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