Actual Cash Value vs. Replacement Cost: Which One Will Never Pay Your Full Claim?
Homeowners want to pay the lowest premiums possible while maximizing their coverage in the event of a loss. That's why it is so important for home insurance policyholders to understand their coverage options. What is the difference between actual cash value coverage and replacement cost when it comes to homeowners insurance?
Understanding the Differences in Coverage Options
Most standard homeowner insurance polices will cover your home -- the actual building in which you live -- at a limit higher than what you probably paid to buy or build it. Why? Because it will no doubt cost more to build a brand new home on your property in the event the current structure is completely destroyed. This coverage is called replacement cost, and most standard homeowners insurance policies offer this as default coverage for your house.
The same cannot be said of the belongings kept inside your home. Most basic homeowners insurance policies offer the default coverage of actual cash value for personal property. You can choose to cover your personal property at replacement cost, instead. What's the difference?
There are two main methods insurance companies use to calculate the amount they will reimburse homeowners policyholders after a personal property loss:
- Replacement cost: The cost of a brand-new item to replace your stolen, damaged or destroyed item. Your home itself should be insured at replacement cost.
- Actual cash value: The cost of a brand-new item, minus depreciation. In other words, the reimbursement will be the estimated value of your old, used item if you attempted to sell it on the market.
How Is Depreciation Determined?
Different insurance providers have various ways of calculating depreciation. One of the most common methods is to determine the item’s value in relation to its life expectancy.
You can calculate actual cash value using the life expectancy model by dividing one by the life expectancy of your item to find the annual depreciation rate. For example, a sofa with a 10-year lifespan will depreciate by 10% each year. If you paid $1,500 for a sofa seven years ago, you can determine its actual cash value by calculating:
- $1,500 x 10% = $150
- $150 x 7 years = $1,050
- $1,500 - $1,050 = $450 actual cash value
Many homeowners discover the discrepancy between the insurance company's reimbursement check and what it costs to replace an item only after they file a claim. Trying to replace a $1,500 sofa with $450 will be difficult, and the homeowner has to come up with the difference. In this same scenario, the cost to replace that old sofa with a brand-new one of similar materials and style may be $1,900. If your policy offers replacement cost coverage, you will receive $1,900 rather than $450.
Homeowners can really take a hit because of depreciation when it comes to electronics. If you paid top dollar for a flat screen LED TV when they were first coming on the market more than five years ago, you may be shocked to learn what its actual cash value may be as determined by an insurance company.
Other formulas are used to determine depreciation, and factor in wear and tear as well as age. Some of the equations are complex and computer algorithms are often used. It's always a good idea to ask your insurance agent how reimbursement rates are calculated by your homeowners insurance policy and company.
What If My Property Has Appreciated in Value?
One would think that if insurance companies take depreciation into account when reimbursing homeowners, they would also consider increases in the value of items over time. Unfortunately, this is not the case.
Personal property such as autographed sports memorabilia, artwork, fine jewelry, and antique china that often appreciate in value over the years are not given special consideration by insurance companies.
In fact, in order to be sufficiently insured against losses for these types of personal property, you may need to purchase additional riders to your homeowners insurance policy. Coverage for this type of property is often capped as a percentage of your home's value in terms of what you would receive after a loss. For example, if your home is insured for $250,000, your policy may cap any benefits for jewelry at $2,500. One stunning piece in your collection could actually be worth twice that.
If you own valuable jewelry, a firearm collection or artwork, ask your insurance agent about coverage options that will protect you from catastrophic losses in the event these items are damaged, lost or stolen.
Is Actual Cash Value Ever Better Than Replacement Cost Coverage?
Some homeowners opt for actual cash value coverage because their insurance premiums are lower than if they chose a policy that offers replacement cost. While standard homeowners insurance will cover your house with replacement cost, it may be possible to choose actual cash value to cover the home itself. That option may depend on whether you are still paying the mortgage on the property, however, as your lender may require a higher level of insurance in that event.
If you or your spouse is a contractor or works in the construction industry, opting for the cheaper coverage and doing the majority of home repairs yourself may be the wiser choice. For example, say your 20-year-old roof is insured at actual cash value. A windstorm damages so many shingles it needs to be replaced. Perhaps having a new roof put on would cost $15,000, but your insurance company will only reimburse you $8,000 due to the roof's age. If you can purchase the materials for $5,000 and do the work yourself with a little help from friends and family, this may be the better option than replacement cost coverage.
Another case where actual cash value for contents coverage may be a better decision is in the event you are renting out the home. You can save on your premiums, as most landlords require their renters to be responsible for insuring the personal property stored inside.
Can I Change My Mind Concerning My Coverage Options?
Absolutely! You may have decided to go with actual cash value insurance coverage when you first purchased your home in order to save a bit of money. Perhaps now that you have settled into the house, you can afford slightly higher premiums for the expanded coverage offered by replacement cost. Or maybe you are now renting out a home in which you used to live and would rather choose actual cash value.
Either way, it's always recommended to review your homeowners policy options every year to make sure your coverage options are still the best choice for your current circumstances.