When it comes to homeowners, renters, or property insurance, you’ve got a lot of choices to make. How much coverage do you need? What deductible can you afford? Which possessions or parts of the property need covered? One of the biggest choices is one that very few insurance buyers understand: actual cash value versus replacement cost.
Here, we’ll explain the differences between these two options, and when you might need to use each one.
What is Actual Cash Value?
Let’s start with actual cash value, which seems like the more intuitive option of the two. As you might guess, actual cash value is often defined as the “fair market value” of the property you’re insuring. It’s not what you originally paid for the item.
So if you’re insuring a car, for instance, its actual cash value could be much lower than what you paid for it or even owe on it. (This is why gap insurance comes in so helpful with financed vehicles.) But on property that tends to appreciate–increase in value–the actual cash value could be more than you originally paid. This is more likely to happen with something like a home or an antique piece of furniture.
However, the International Risk Management Institute notes that actual cash value can be calculated differently depending on legislation and case history in your state. For instance, in California, a court ruling said that the term “actual cash value” means fair market value. So this is what you could have sold your home for under current market conditions, usually excluding the cost of the lot your home sits on.
How is Actual Cash Value Calculated?
With all that said, calculating actual cash value can get complicated. Value is subjective. However, insurers often use something called the broad evidence rule to measure actual cash value. This means insurers look at things like the home’s replacement costs, the age of the property, the profit you may have made from the property, and the property’s tax value.
Typically, if your insurance policy states that it will use “actual cash value” or “market value” in your policy, that’s what it means. However, some insurance policies define the limit as replacement costs minus depreciation. So that’s what it would take to rebuild your home, minus depreciation that would have occurred over time. Also, the value of the land your home sits on probably doesn’t count towards the calculation.
The key here is to figure out exactly how your insurance policy defines actual cash value, preferably before you choose that particular policy.
What is Replacement Cost?
What if your insurance policy calls for replacement costs? In this case, you’re insured for up to the amount that it would cost to completely rebuild a very similar home. Or, if you’re insuring personal property, replacement cost is what it would cost you to purchase the same item new.
Typically, an insurance company will write a replacement cost policy strictly. For instance, when you’re rebuilding your new kitchen, you don’t get to upgrade from laminate to granite countertops and have your insurance company eat the difference.
There are a couple of things to keep in mind with replacement cost calculations, particularly for homeowners insurance:
- Market value vs. rebuilding value: Your home may cost more or less to rebuild from scratch than it would cost on the market. So this will be taken into account in the policy.
- Cost of the land: Even if the worst should happen, you still wouldn’t have to re-buy the land your home sits on. This can mean replacement costs are significantly lower than cash value. Also, the builders may be able to reuse the home’s foundation, which also cuts down on costs.
- Age of the home: Older homes can be more expensive to insure through replacement costs because it could get very expensive to replace that hand-milled woodwork and hardwood flooring. Keep this in mind if you have a historic home.
Either Option Comes with More Options
Many homeowners insurance policies include a cap. So you can insure your home for replacement costs up to a certain dollar limit. However, insurers often offer additional options to consider, including:
- Guaranteed Rebuild: This is like a replacement cost insurance policy, except without the cap. Whatever it costs to rebuild your home with similar materials and types of construction, the insurance company will pay in the event of a total loss. Since they could be more expensive for insurers, these policies are more expensive.
- Replacement Cost: With this traditional replacement cost option, you’ll work with your agent to basically guess your home’s replacement cost. If you’re wrong and it costs more to replace the home than your policy covers, you’re on the hook for the rest.
- Actual Cash Value: As noted above, some insurers differentiate this from market value, using instead its replacement costs less depreciation. But your insurance policy should define this.
- Market Value: This is what someone would pay for your home on today’s market. Again, you’ll typically work with your insurance agent to set a cap on this type of insurance.
So Which is Best for You?
As with most questions in personal finance, the answer is that it depends.
For the majority of homeowners, a replacement cost policy will be best. You want to know for sure that you could rebuild your home should the worst happen. With that said, if you have an older home, a replacement cost policy could get very expensive.
This type of policy simply won’t allow you to replace hand-carved oak paneling with cheap stuff from the hardware store, for instance. And you’d have to pay a lot more for labor to work with your higher-quality or old-fashioned materials, too.
So if you have an older home, you might opt for a market value policy, which will be more affordable. If your home burned down, you wouldn’t be able to replace it just like it is now. But you’d also not have to pay through the nose for insurance coverage.
On a personal note, my husband and I made that very decision a few years ago when we moved into our home, which was built in 1900. A replacement cost policy would have been well outside of our budget. So we opted for a cash value policy with a generous limit. If our home burned down, we’d probably just sell the lot and buy another home in our reasonably-affordable neighborhood.
That won’t be the right decision for everyone. And if you can afford it, a guaranteed rebuild type policy for an older home is great. But if it’s outside your budget, some coverage is always better than none.
You’ll also need to take into account your mortgage lender’s requirements. Lenders nearly always require that you carry homeowners insurance on a mortgaged property. But their specific requirements vary. You may find that lenders require the property to be insured for at least the amount of the mortgage. Your lender may be stricter, though. For instance, your lender could require that you get a replacement cost policy.
A Note About Personal Property Coverage
Actual cash value, market value, and replacement cost all apply to personal property insurance coverage, too. They apply to the personal property coverage that’s likely built into your homeowner’s policy, as well. And since a renters insurance policy is essentially a personal property policy, it applies here, too.
Again, the key is to know what your insurance company means, and then to decide which option is best for your needs.
Are you a low-budget college student who just needs basic renters insurance? An actual cash value policy could be super cheap. It doesn’t give you the ability to replace everything new if something happens. But at least you’d have some cash to shop garage sales and Craigslist to refurnish your home and get the basics.
If you can afford a replacement cost policy for your personal property, it could make your life much easier. Just think about things like your couch. So you have a leather couch you got secondhand for $1,000 on Craigslist?
If a tree falls through your roof and ruins the couch, do you really want to have to shop around forever to find a new-to-you one? Or do you just want to take $2,000 from the insurance company to buy a similar couch brand new?
When it comes down to it, most property insurance is pretty cheap. So it’s best to just spring for replacement cost coverage and be done with it. If your policy would be too expensive because of a specific item, like heirloom jewelry or artwork, consider adding a separate rider for those particular items.