Homeowner’s insurance: Replacement cost versus actual cost

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Michaela Phillips, Guaranteed Rate, Inc.

Michaela Phillips,
Guaranteed Rate, Inc.

Lenders are not as nervous to lend as they were a few years ago; as the recession abated, confidence rose. But this doesn’t mean they’re not changing things up. Nowadays, some are adapting their insurance requirements and mandating that home owners have replacement cost coverage policies. This is because replacement cost protects the lender (and the home owner) in the event of a catastrophe.

Insurance companies offer two types of coverage: actual cost and replacement cost.

Replacement cost
Replacement cost fully reimburses the insured for damaged or stolen property. Damage is usually incurred as the result of a weather-related event – a tornado or hail storm – or as the result of some other incident (a baseball sailing through a bay window, for instance).
It may be the result of a fire, as well.

Damage as the result of overuse or misuse is not covered by insurers. Insurers will also not repair any item when the cost to repair it exceeds the cost to replace it. Replacement cost doesn’t consider the condition a piece of property was in at the time it was damaged.
It doesn’t consider an item’s age, either.

Actual cost
Actual cost (or actual cash value) is designed under the same intention as a replacement cost policy: it reimburses the insurer for damaged or stolen property. However, actual cost will only cover part of the replacement cost. This is the key difference between this type of policy and a replacement value policy.

Actual cost considers depreciation the same way a person selling gym equipment on Craigslist considers it: a seller doesn’t post an ad asking for the original cost of the item (or, if they do, they probably don’t have many takers). Instead, he or she posts an ad asking for the equipment’s worth after years of use. Actual value policies do the same – the insurer determines the value of the property by weighing several factors, including condition and wear and tear.

Actual cost is a mainstay of car insurers. When a vehicle is totaled in an accident, the insurers pay for the car’s value at that time; they do not pay for the vehicle’s original purchase price.

The benefits of each
Both replacement cost polices and actual cost policies offer benefits. The former offers home owners more protection, comprehensive home repairs, and works better with aging properties. The latter is more affordable, allows home owners to do large repairs themselves, and is a better choice for anyone hoping to turn a profit on their rental property.

When it’s all said and done, home owners may not have a choice of policy; it really depends on the lender. But – for those who do – each policy offers pros and cons.

By Michaela Phillips, Guaranteed Rate, Inc. Michaela Phillips is the Vice President of Mortgage Lending at Guaranteed Rate, Inc. Contact Michaela at 303.579.5517, e-mail michaela@michaelaphillips.com or visit michaelaphillips.com. NMLS:312874.

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