Replacement cost vs. market value in homeowners insurance

When you purchase a home, your mortgage lender will require you to obtain home insurance before closing. And as you’re comparing homeowners insurance policies, one of the biggest questions you’ll encounter is how much home insurance you need. You’ll also need to determine if you should cover your home for its replacement cost or market value.

Replacement cost refers to the cost to entirely replace your home, whereas market value is the amount a buyer would be willing to pay for your home in its current condition. Understanding the differences between replacement cost and market value can help you make an informed choice that protects your home and your family’s financial future.

Here’s what you need to know about replacement cost vs. market value.

• What’s the difference between replacement cost and market value?
• Factors that can affect replacement cost vs. market value
• When is replacement cost more expensive than market value?
• Calculating the replacement cost of your home
• Should you insure your home at market value?
• Should you insure your home at replacement cost?

What’s the difference between replacement cost and market value?

Many policyholders believe replacement cost and market value are interchangeable, but they’re two distinct valuation methods.

Replacement cost is the amount you would need to replace or rebuild your home. If disaster strikes and you’re forced to rebuild your home, your insurer will reimburse you for the cost of rebuilding or repairing your home (up to your coverage limits). Your insurer will typically replace your home with one of similar size, using similar materials.

Keep in mind, your home’s estimated replacement cost may increase if you make improvements to your home. Similarly, the replacement cost could also rise if labor, materials, and transportation costs increase. It’s wise to review your homeowners insurance policy every year to ensure you have enough coverage. You might also want to consider adding an inflation clause that automatically adjusts your coverage amount when construction costs change.

HOW MUCH HOME INSURANCE DO I NEED?

By contrast, market value is what your home is worth on the real estate market. The market value approach focuses on lot size, location, quality of area schools, local crime statistics, and recent sales prices for similar homes in the neighborhood.

Market values tend to fluctuate. Sometimes, the cost to replace a home is less than the home’s market value, and other times, the market value of a home is less than the home’s replacement cost. In this case, if your homeowners insurance policy only covers up to the market value, you could end up receiving an insurance settlement that’s insufficient to cover the actual replacement cost of your home. This scenario leaves you in the unenviable position of having to come up with the financial difference yourself.

Factors that can affect replacement cost vs. market value

Whether you insure your home for its replacement cost or market value, remember that several factors contribute to both of these valuations. As such, the replacement cost and market value can change over time. Here are some of the most common factors that contribute to your home’s replacement cost and market value:

Replacement cost

• Age of the home — Older homes may include materials and features which are more difficult to replace.
• Square footage — Builders typically charge by the foot to build a home. The larger your home, the more it’ll cost to replace.
• Location — Your home’s location affects prices for labor and materials.
• Labor costs — The availability of skilled labor may be limited and more expensive after a catastrophe. Labor costs also increase over time with inflation.
• Building materials — The cost of building materials tends to rise after a catastrophe when demand is higher. Like labor costs, these costs rise over time.
• Zoning and code compliance — If you have to rebuild your home, your home will have to meet local zoning and building code requirements, which could influence your home’s replacement cost.

Market value

• Location — Things like close proximity to schools or being near the ocean increase the market value of your home.
• Square footage — A large home with an abundance of livable space is typically worth more than a similar but smaller home in the same market.
• Housing supply and demand — Property value can rise or fall in line with housing market conditions at any given time. A low inventory of available homes generally drives home prices up. Conversely, home prices tend to be lower when housing inventory is high.
• Land value — Lot size also impacts your home’s market value. Your home may be worth more if it has more usable land than a similar home on a smaller lot.
• Comparable sales — "Comps" are comparable nearby homes that have sold recently. Since these homes are typically the same age, size, and have the same number of bedrooms and bathrooms, their sales price could influence the market value of your home.
• Crime rates — Your area’s crime rate affects the market value of your home. The less crime that occurs in the area, the higher the market value of the home.

When is replacement cost more expensive than market value?

The replacement cost of a home may be more or less than its market value, but certain situations can make it more expensive than market value.

If your home is in a less-desirable area, the replacement cost may be higher, since the location would lower the market value. Or, if your home was priced low or you purchased it in a short sale, the market value may have been less than what it would cost to rebuild. That’s because the replacement cost doesn’t take into account housing market valuation elements like housing inventory, lot size, neighborhood, and other factors.

On the other hand, your home’s market value could be higher than its replacement cost since market value accounts for the land your home sits on. You wouldn’t need to pay for the land if you rebuilt, so replacement cost doesn’t factor this in.

Calculating the replacement cost of your home

If you want to calculate an estimate of your home’s replacement cost yourself, you can use a simple formula. But other methods will give you a more accurate number. Here are a few options for calculating your home’s replacement cost:

Multiply square footage by building costs

Perhaps the easiest way to get a ballpark figure is to use the average per-square-foot rebuilding cost for your area and multiply that amount by your home’s total square footage. A local real estate agent or an insurance agent can help you determine construction costs.

Local rebuild cost per square foot x Total home square footage = Replacement cost value (RCV)

So, if contractors in your area charge an average of $100 per square foot to rebuild a home, and your home is 1,500 square feet, then the replacement cost value for your home is approximately $150,000.

WHAT’S THE AVERAGE COST OF HOMEOWNERS INSURANCE?

Get an insurance appraisal

Another way to calculate the replacement cost value is to get a home appraisal from your insurance provider. Many insurance carriers use software to calculate your replacement cost value. Keep in mind, the calculation is only as good as the information you give your agent. It’s essential to provide your insurer with complete and correct details for a more accurate quote.

Hire a professional contractor or appraiser

If you want the most accurate RCV calculation, consider hiring a professional appraiser in your area who can perform an in-person inspection of your home. A local professional is much more likely to understand your city’s ordinances and building costs.

Should you insure your home at market value?

As with any financial product, it’s always best to weigh the benefits and drawbacks before coming to a conclusion. For instance, insuring your home for its market value may make sense when the housing market is hot and home values are high. But that could change quickly if housing demand sours in the open market.

Benefits of market value homeowners insurance

• Market value could be higher than replacement cost. Your home’s market value may exceed its replacement value if it features unique artisanal work or rare materials that would be costly to replace.
• Save money. If your home’s market value is lower than its replacement cost, it can be cheaper to insure it for market value.

Drawbacks of market value homeowners insurance

• You risk being underinsured. Since construction costs typically rise over time, you could end up with a market value that’s below the home’s value. If a disaster strikes your home, forcing you to rebuild, you’d have to make up the difference or build a less expensive home.
• You risk overpaying for coverage. While you save money on your premiums if your home’s value in your local market is higher than its replacement cost, the opposite is true if your home’s value wanes during an economic downturn or depression. If you don’t adjust the policy during these periods, you could end up paying more for coverage than you might with a replacement cost valuation.

WHAT IS EXTENDED REPLACEMENT COST FOR HOMEOWNERS INSURANCE?

Should you insure your home at replacement cost?

It’s typically a good idea to insure your home at its replacement cost, particularly in a down market when forces like supply and demand, area crime statistics, and the quality of your local schools can drive down your home’s value.

Benefits of replacement cost homeowners insurance

• Housing market conditions have no impact. Your policy can completely replace your home (up to your coverage limit) regardless of changes in the housing market.
• It provides reliable protection. Replacement cost coverage can help your family rebuild your home and reclaim your quality of life. It’s wise to insure your home for at least 100% of its estimated replacement cost.

Drawbacks of replacement cost homeowners insurance

• You can’t take advantage of increasing home values. If you live in a high-growth area, your home’s value could appreciate substantially more than the cost to replace it.
• Replacement values fluctuate. You could end up with inadequate homeowners insurance coverage if rebuilding costs increase. Remember to review your policy with your agent annually to make sure your policy keeps up with rising building costs. Also, notify your agent if you’ve made any home improvements that could increase the cost of replacing your home.