When choosing homeowners insurance, you have the option to insure your home at either market value or replacement cost. If your home is destroyed, the difference in these two types of coverage is crucial and can be expensive. Here’s why you need to insure your home at replacement cost.
Defining market value and replacement cost
Market value is just what it sounds like: what your home would sell for on the open market. It’s much like a Comparative Market Analysis (CMA) that a real estate agent would use. This amount is influenced by home values in your area and includes the value of the lot on which the house sits.
Replacement cost is the estimate of what it would cost to repair or rebuild your home after a partial or total loss. It calculates the potential cost of labor and materials needed to restore the home to its previous condition. You can get an estimate of the cost to replace your home through a professional contractor assessment, or your insurance agent may have a program that calculates it.
Why is the difference important?
Insuring at market value carries a substantial risk of being underinsured. For example, suppose you bought the home for $225,000 and insured at that amount when you first bought your policy. Over time, the cost to repair or replace that home ratchets upward. If a fire destroys the home years after it was insured at market value, the cost of replacement might now be $260,000. In that case, you would be responsible for the $35,000 difference out of pocket.
Insuring at replacement cost relieves that risk. Each year, your insurance adjusts the amount of coverage upward to keep pace with rising construction costs. This can be done either through annual reviews with your insurance agent or with an automatic inflation adjustment clause in your policy.
Contact your insurance agent to set up an annual review of your home’s coverage or to add an inflation adjustment clause.