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Is insuring the property for the amount required by the lender enough? Before we answer that question we need to look at four different measures of the value of your home:
The Mortgage Balance is the amount outstanding on your loan. From the lender's standpoint, this is the value of your dwelling. This value does not in any way relate to the actual cost of replacing your home in the event of a total loss and should never be used as the limit selected for the dwelling.
Simply put, the market value is the cost one would pay for a home and property when the seller is not being forced to sell the property and the buyer is not under any special urgency to make the purchase.
The most critical value from an insurance standpoint is the replacement cost. This amount is the dollar value it would take to rebuild your home with like kind and quality of materials at the current construction costs for your local area. This is the amount you should be insuring your house for.
The difference between market value and replacement value is simple. Picture a hypothetical house in a quiet neighborhood built across the street from a public park. Now imagine that exact same house, but this time place it across the street from a garbage dump and with a major highway running behind the property. In both cases the replacement cost will be exactly the same, but the market value will vary dramatically. The policy is structured to enable you to rebuild on the same site a substantially similar structure, replacement cost is the measure of that value.
Actual Cash Value
The final value a homeowner's policyholder must be concerned about is actual cash value (a.k.a. depreciated value). Actual cash value (ACV), simply stated, is today's cost to repair or replace a dwelling minus functional depreciation. Depreciation is the reduction in an item's worth as it gets older. For example, the roof on a dwelling should last for 20 years. Thus, if it costs $20,000 to replace a ten-year-old roof destroyed by a fire, the actual cash value of that roof is $10,000.
Age of roof = 10 Years
--------------------------- = .50
Expected life span = 20 Years
Replacement cost $20,000 x .50 = $10,000 actual cash value
In this case, the homeowner has received the benefit of the roof for 50% of its anticipated useful life. The company would only pay $10,000 to replace a ten-year-old roof, even though the cost of such a replacement is $20,000.
While almost all homeowners' policies will pay for replacement cost, they will only do so if the amount of insurance carried is equal to 80% of the replacement cost at the time of the loss. If it is determined that the amount of insurance carried in the policy is less than the required 80% then the settlement of a loss will be made on the actual cash value basis. This can be financially devastating to the homeowner in the event of a significant loss.
SUGGESTION: Your insurance agent has a number of tools at his or her disposal to assist you in determining the replacement value of your home.
IMPORTANT NOTE: Even if your home decreases in value due to market forces in your area, the cost of replacing that home will most probably increase each year, as the cost of construction and materials goes up. Your insurance company may increase the amount of your insurance each year based upon a cost of construction index for your local area. Remember, if you make modifications to your house that would increase the cost of rebuilding, let your agent know. They can help you determine how much additional coverage you might need based upon the new construction.
In today's real estate market, you may find that the replacement cost of your home is less than the outstanding balance on your mortgage. This is because your mortgage is based upon the total market value of your property, while the insurance is only concerned with the replacement cost.
In most cases your insurance agent will resolve this problem by obtaining coverage with some form of guaranteed dwelling replacement cost provision. The terms of this added coverage can vary from company to company, but in general it is an agreement to provide protection above the stated limit for the dwelling in amounts equal to 25, 50, or even 100% of the listed replacement cost for the dwelling. For usually a nominal fee, you don't pay the full cost for this added protection unless you actually use it in the settlement of a loss. A guaranteed dwelling replacement cost endorsement will almost always be satisfactory in those instances where the replacement cost of a dwelling is less than the outstanding balance of the loan.
SUGGESTION: The use of a guaranteed replacement cost endorsement is a good idea even if your mortgage balance is less than the replacement cost of your home or even if you own your property free and clear.
SUGGESTION: If your home is over 20 years old or your community has upgraded to new building codes since the property was built, consider including an endorsement to your policy which will cover the added cost of rebuilding to meet the higher standards.