Understanding Replacement Cost vs. Actual Cash Value in Home Insurance

Let’s say your home and possessions are seriously damaged in a natural disaster. Since you’re a savvy homeowner, you have a solid homeowners insurance policy, so your home and your belongings are covered.

But do you know how much they’re covered for, and how your insurance company is going to determine their value? Whether their actual cash value or their replacement value is covered can translate to tens or even hundreds of thousands of dollars of difference in potential protection. Read on to learn the difference between the two, and when each type of coverage is most appropriate.

What is actual cash value?

Actual cash value, or ACV, is the cost of replacing a damaged or lost item, minus depreciation. Depreciation is the market value the item has lost over time.

For example, let’s say you bought a high-end television five years ago, and it was recently destroyed in a house fire. You originally paid $2,000 for it, but because of depreciation, its actual cash value is going to be a fraction of that.

How much value it’s lost is going to depend on what the insurance company considers its useful lifespan. Just as your financial history can affect your ability to buy a home, your possessions’ lifespans will determine how much of an insurance payout you can get. If the television is five years into a fifteen-year lifespan, you’re looking at a 33% reduction; if it’s five years into a ten-year lifespan, it’ll be a 50% reduction.

If its actual cash value is covered under your home insurance policy, you’re going to be reimbursed for that smaller amount— not the $2,000 you paid for it initially, or the cost of buying a comparable television today.

Don’t forget that this reimbursement amount is also affected by your deductible. If you haven’t yet met your deductible through filing other claims, your deductible amount will be taken out of your reimbursement.

What is replacement cost?

As you can probably deduce from the name, replacement cost coverage covers the full cost of replacing your damaged or lost items. Depreciation isn’t a factor in replacement cost coverage.

So going back to the previous example of the five-year-old television that cost $2,000. Even if that television was halfway through its useful lifespan, your home insurance will pay the full amount of a comparable replacement.

How this would typically work is you’d first file a home insurance claim. Then you’d receive a check for the actual cash value of your item. If your $2,000 television was halfway through its useful lifespan, you’d receive an initial check for $1,000 (minus your deductible). Then, after you purchase an equivalent replacement television, the insurance company will send you another check for the difference between the amount you’ve already received and how much the replacement costs.

This can be a lengthy process. Make sure you understand potential timelines and how they might restrict your options in the meantime; for example, it can be complicated to sell a house with an open home insurance claim.

Types of replacement cost coverage

If your policy has a coverage cap, it might not cover the actual full replacement cost of your home or possession.

As an example, let’s say your home is severely damaged in a natural disaster, and it’s going to cost $650,000 to build a replacement. If your policy has a coverage cap of $500,000, you’ll have to come up with that extra $150,000 out of your pocket. If you can’t come up with that money, you may have to quickly sell your damaged home to a company that buys houses as-is for cash, and look for an alternative living arrangement.

Because of this coverage gap, various types of replacement cost coverage can give you extra peace of mind.

Guaranteed replacement cost

This is exactly what it sounds like: a guarantee that your policy will cover the full replacement cost of your home even if it exceeds your coverage cap. Although this type of add-on can be costly, it can be worth it if your property is located in a high-risk area like a flood plain.

Extended replacement cost

This is a slightly more limited add-on, but it works on the same principle. The extended replacement cost covers a certain percentage above your policy’s coverage cap— usually around 10-25%.

How do you know if you need this type of extended replacement cost coverage? Check your homeowner's insurance policy to see what your coverage cap is, and then look up your home’s value on a trusted home value website. If your home’s value is higher than your coverage cap, you should probably consider extended coverage.

Which is better — actual cash value or replacement cost?

Asking which type of coverage is better is like asking if Zillow or Redfin is the better home valuation website; each option has different pros and cons. Homeowners and renters insurance policies generally come with actual cash value coverage by default, but you can change to replacement cost coverage.

Replacement cost is favored for your home itself since you’ll need an entirely new home if your present home is destroyed or seriously damaged. On the other hand, actual cash value coverage is generally favored for your possessions like electronics, furniture, clothing, and other personal items.

Then there’s the money factor. Since replacement cost coverage gives a more comprehensive level of protection, it tends to be somewhat pricey. Actual cash value coverage, on the other hand, comes with more affordable premiums. If money is a consideration, actual cash value coverage might be more palatable.

Ultimately, the right homeowners insurance policy for you is going to depend on several factors, both internal and external. Objectively assess your risk profile, determine what you’re comfortable with both financially and psychologically, and consult with your insurance agent to figure out the best policy for your needs.