Market Value vs. Replacement Cost

by Steve Wilson on March 29, 2010 · 0 comments

in Homeowner's

Burning-House--29113

*Photo courtesy FreakingNews.Com

Homes all across the nation have been decreasing in value – in some areas up to 30% or 40% in the past 3 years! Meanwhile, the cost of labor and construction materials have increased dramatically due to increased global demand for lumber, steel and concrete.

What does this mean for your insurance plan?

With your home likely being one of the biggest assets, you want it adequately protected. What is adequate protection? Do you insure it for the amount you paid for your home? Do you insure it for the (shrinking) resale value?

The answer is, neither.

Think of it this way- Your insurance serves to restore your home to its pre-loss state. That means, if your house burns down or is blown away by tornadic winds, you want a policy that pays the cost to replace your home, taking into consideration any increases in construction costs. In other words, you want a policy that offers replacement cost as opposed to actual cash value (ACV).  Keep in mind that rebuilding after a major loss actually costs more than new construction, because you also have to account for demolition and debris removal expenses, as well as the difficulties in building within a developed neighborhood.  If building costs continue to rise, it means that your homeowner’s policy should be reviewed regularly to make sure that it is structured to provide adequate protection.

There are different methods to determine the value of a house. Market value is the price paid for your house. Replacement cost is the price or cost it will take to rebuild your house in the same spot, same size and same quality of construction, at today’s costs. Insurance companies use the replacement cost valuation. These can be two completely different numbers.

For example, a home purchased in a depressed city neighborhood, may have a market value of $120,000. The exact house, located in a nice suburb, may have a market price of $285,000; however, the cost to rebuild the house after a loss would be the same in either location. The insurance company is looking to insure the home for the full replacement value, not the current market value. Remember, they are going to pay to build you a new home, not buy one for you down the street.

Thriving Suburb
Depressed Neighborhood
Square Footage
2,500
2,500
Year Built
1920
1920
Market Value

$285,000

$120,000

Cost to Replace Home
$275,000
$275,000

For insurance purposes, you should insure your home to 100% of it’s replacement cost. This will ensure the ability to rebuild the entire house, the way it is now, in the event of a total loss.

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