Actual cash value vs replacement cost

Lisa Melillo
Lisa Melillo
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Setting a limit for your homeowners or renters insurance policy is fairly straightforward. However, deciding between actual cash value vs. replacement cost reimbursement isn’t always as easy.

For most people with renters or homeowners insurance, replacement cost coverage is the most advantageous if you need to file a major claim. However, this coverage comes at a cost – one that might not be worth it for every individual. We’ll help you understand the differences between actual cash value and replacement cost so that you can weigh the pros and cons for yourself.  

What Is Actual Cash Value Coverage?

Actual cash value is an item’s fair market value at the time that you file a claim. This value is determined by taking the cost of buying a new item (also known as its replacement cost) and subtracting depreciation. The longer you’ve owned an item, the lower its actual cash value.

Let’s use a TV as an example. If you purchase a brand new model for $400, you won’t be able to sell it for the same $400 two years later. The most someone will pay for a used TV after two years of wear and tear might be just $300. This depreciated market price is what insurance companies try to estimate when calculating an item’s actual cash value.

There are both pros and cons to choosing actual cash value coverage. The advantage is that your premiums will be lower, which is helpful if you’re hoping to save money on your monthly bills. On the other hand, you’ll get less money from the insurance company in the event of a claim.

How Does Actual Cash Value Work?

To calculate an item’s actual cash value, the insurance company first needs to determine its estimated lifespan or the number of years you would typically be able to use it before you needed to buy a new one. When you file a claim, they’ll look at the number of years you’ve owned the item and reimburse you for the remaining percentage of its lifespan.

For example, let’s say your TV has an eight-year lifespan, but you’ve only owned it for two years. Your insurance company will set the TV’s actual cash value based on the remaining 75% of its lifespan. If it costs $400 to replace the TV, you’ll get $300 from the insurance company. File a claim after three years and the actual cash value drops to $250. This continues until the item reaches its full lifespan, at which point its value will be considered $0.

What Is Replacement Cost Coverage?

Unlike actual cash value coverage, replacement cost coverage doesn’t consider depreciation when determining how much your belongings are worth. If you file a claim, your insurer will provide you with the funds to replace each item with a new equivalent. In most cases, this amount remains the same regardless of how long you own the item.

With replacement cost coverage, a $400 TV will be reimbursed at its full amount even if you’ve already owned it for a couple of years when you file a claim. (Keep in mind, though, that your deductible will still be subtracted from the total amount you receive.)

Replacement cost coverage may pay out higher claim amounts, but it also costs more than actual cost value coverage. You’ll have to weigh this tradeoff when purchasing your policy.

How Does Replacement Cost Work?

When you submit a claim to your insurance company for an item’s replacement value, the adjuster will research its market value based on the description you provide. This is why it’s important to be extremely detailed when creating a home inventory for your homeowners or renters insurance.

If you simply list a 50-inch TV, for example, then the insurance company will likely only pay for the least expensive model that fits this vague description. Try to provide as many details as possible, such as the item’s defining characteristics and a list of any special features. Including documentation, such as a serial number and receipt showing the original purchase price, is the best way to ensure you’re fairly reimbursed.

Guaranteed vs. Extended Homeowners Insurance Replacement Cost

There are many different ways to calculate homeowners insurance replacement costs depending on the type of coverage. Under the dwelling portion of your policy, your insurer may let you upgrade to guaranteed or extended replacement cost coverage. Both of these options are designed to help rebuild your home in the event of a total loss if construction costs exceed your policy limit.

With extended replacement cost coverage, your insurer will give you a cushion up to a certain amount above what your dwelling is insured for, usually around 25%. For example, if you have $200,000 in dwelling coverage and end up needing more funds to rebuild your home to its previous specifications, extended replacement cost coverage will pay up to $250,000. Once you’ve exceeded this limit, however, you’ll have to either pay out of pocket or build a smaller home.

If you select guaranteed replacement cost coverage, you won’t face a set limit should you need to rebuild your home. While this may seem like an unlikely scenario, it’s more common than you might think, often occurring after a natural disaster destroys many homes in the same area. If large numbers of homeowners need to rebuild at once, this may drive up the cost of materials and labor far more than 25% above their usual price.

Actual Cash Value vs. Replacement Cost, Which One Should I Get?

By default, most insurance policies come with actual cash value reimbursement since this is the less expensive type of coverage. However, you may wonder if it’s worth increasing coverage to include reimbursement for your belongings’ replacement cost.

If a major disaster, like a fire, destroys most of what you own, replacement cost is the type of coverage you want to have. But since the chance of this happening is relatively low, you’ll need to weigh it against the price of upgrading your policy. Location is a major factor in determining how much replacement cost coverage will increase your premiums; depending on where you live, it might not be worth it.

First-time homebuyers who have recently purchased most of their furniture new can save money by foregoing replacement cost coverage for the first couple of years. During this time, each item’s actual cash value isn’t too far off from its replacement cost. Once depreciation begins to accumulate, you can always upgrade coverage during subsequent policy renewal.

The Bottom Line

Deciding between actual cash value vs. replacement cost coverage is just as important as setting the limits on your homeowners or renters insurance policy. The type of coverage you choose can have an enormous effect on how much money you receive from your insurance company if an unthinkable tragedy destroys your belongings. If you end up deciding on actual cash value coverage, consider keeping a bit of extra cash in your emergency fund to cover the depreciation that your insurer won’t reimburse.

About the Authors

Lisa Melillo is a personal finance writer for Reviews.com. Over the past seven years, she’s covered insurance, travel, and home-related topics for a variety of online publications and businesses.