After purchasing a homeowners insurance policy and looking at your coverage amounts, you may be left wondering why they're higher or lower than the home's market value. There's a simple reason for this: Your home's insurance amounts are based on its replacement cost, or the cost to rebuild, not the amount it would sell for on the housing market.
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Replacement cost vs. market value: What’s the difference?
Replacement cost is the amount it would take to repair or rebuild your home at the current prices of construction materials and labor. If your home is destroyed in a fire, for example, your insurer will reimburse you for the cost of rebuilding the house to the way it was before, using materials of similar type and quality (up to your coverage limits).
Market value is the amount your home is worth on the housing market. It takes into account the value of the home itself, its location appeal, the land on which it's built, and the amount that other home’s in the area are being sold for. A home’s market value is often higher than its replacement cost, but this can vary depending on the age of the home and its location.
The table below illustrates the various factors that can impact replacement cost and market value.
Replacement cost | Market value | |
|---|---|---|
Age of the home | ✓ | ✓ |
Square footage of the home | ✓ | ✓ |
Local labor costs | ✓ | |
Local construction costs | ✓ | |
Property demolition and debris removal costs | ✓ | |
The home's architectural style | ✓ | ✓ |
The value of the land itself | ✓ | |
Housing supply and demand | ✓ | |
Labor and construction supply and demand | ✓ |
Although the vast majority of property owners have homeowners insurance, almost half of them mistakenly think the amount of homeowners insurance they need is based on the market value of their home. Basing your home’s coverage limits on its market value can lead you to being overinsured and paying too much for coverage, or being underinsured and not having high enough policy limits to pay out for a full rebuild in the event of a disaster.
Fortunately, it’s usually not up to the customer to calculate their own coverage limits. Most major insurers today have their own quote estimate tools that automatically generate a home’s replacement cost based on details like its address and square footage.
When is replacement cost higher than market value?
Since market value is only influenced by what buyers are willing to pay for a property and not how much it costs to rebuild, reconstruction costs can actually be higher than what a home is actually worth. This is especially the case if the home is constructed with rarer, more expensive materials or when it's located in an area where the land itself doesn’t have much value.
Here are some instances where the replacement cost (or reconstruction costs) of a home can be higher than its fair market value.
When the home is older or constructed with expensive materials
Generally, older homes cost more to rebuild than newer homes. If you’re insuring a masonry home that’s constructed with a rare type of stone and other materials that are only sold by a handful of suppliers, there’s a chance the cost to rebuild it will be more than its market value.
When the home is located in rural or remote area
A home’s market value is largely influenced by its location. For that reason, you’ll often find that a relatively modest-sized apartment or condo in a popular big city neighborhood is far pricier than a single-family home in the suburbs. If your home is located on a relatively inexpensive plot of land, you may find that its replacement cost is higher than its market value.
Local zoning laws and ordinances can make for higher reconstruction costs
If your home needs to be repaired or rebuilt after a loss, it may need to be reconstructed in accordance with local building codes and ordinances.
If your home is located on a floodplain, for example, it may need to be rebuilt so that water drains away rather than pools around its foundation. The cost to implement these various floodproofing measures will likely cost more than if you were building on a dry parcel of land.
When your insurance company is calculating your replacement cost, they’ll likely consider these factors in the final estimate, which could cause your home’s replacement cost to exceed its market value.
How to insure your home at its replacement cost
Most major insurance companies today will estimate your home’s replacement cost on your behalf. This amount will be either lower or higher than your market value. Both of these instances are common.
But to be on the safe side, you may want to consider getting your own replacement cost estimate from a licensed appraiser who specializes in rebuild cost appraisals. Remember, you’re not looking for a market value appraisal — you want one that is only concerned with how much it would cost to rebuild the physical structure of your home and surrounding structures.
You'll also want to consider adding coverage enhancements like extended replacement cost or guaranteed replacement cost when setting up your policy. These coverages provide you with an added layer of dwelling coverage in the event your policy limits aren't high enough to cover an expensive rebuild.
Frequently asked questions
What is the difference between replacement cost and actual cash value?
Along with replacement cost, actual cash value is another common insurance term that can impact how much you’re paid out for damage or loss to your property. While actual cash value policy options are generally cheaper than the replacement cost variety, they only reimburse you for the depreciated value of the property, or the amount it was worth at the time of the loss. That means if your 10-year-old roof is torn off in a storm, you’re only paid out for the value of a decade-old roof. With replacement cost payouts, you’re reimbursed the value of a new roof.
Can I insure my home at its market value?
If you have the option, you can very well insure your home at its market value, but doing so could make you drastically over or underinsured. If your home is insured for less than 80% of its replacement cost, you’ll only be paid out for its actual cash value, or its depreciated value, in the event of property loss.
What does full replacement value mean?
Full replacement value refers to the amount that it would cost to repair or rebuild your home with materials of comparable value and quality. You generally want to insure your home for at least its full replacement value. Insurance companies offer policy enhancements that can extend your coverage limits or guarantee a rebuild regardless of the loss amount, but this typically costs more than standard policy coverage.
