Market Value vs Replacement Cost: What Is The Difference?
Knowing the difference between market value and replacement cost is key to understanding homeowners' insurance. Essentially, market value measures how much an insurance company would pay you if your house were to be totaled completely. Replacement cost, on the other hand, is what it would actually cost for you to rebuild your home, as opposed to one that's just like yours. The simplest way to explain this distinction is to look at the two ways in which an insurance company determines how much they'll pay out if your home is damaged or destroyed.
When you get a quote for homeowners' insurance, it's important to know that replacement cost and market value can be used interchangeably. It's likely that your insurer will use whichever comes out cheaper for them. So, let's take a look at each of these methods and their advantages and disadvantages.
Pricing Your Home For Replacement Cost
Replacement cost pricing means that your insurer will base their payment on what it would actually cost to replace your home. For example, at the start of the year, if your home is worth $200,000, then your insurer would pay out $200,000 if it was paid off due to fire damage. If you're a landlord, this bill would likely be sent to tenants instead of you as a property owner.
Market Value Pricing
Market value pricing means that your insurer will base their payment on what an insurance company would pay for your home in the current market. This is because replacement cost numbers are usually based on a few factors like what's happening in the housing market as well as existing construction costs in your area. As a result, market value pricing is arguably the most common way to set an insurance company's premium.
With market value pricing, your insurer will likely base its assessment on your home's current value. Keep in mind that this does not necessarily mean they'll pay you the same amount as it would cost for them to build a replacement home; instead, you'll have to pay whatever it would actually cost to rebuild your home. So, how does this work? Let's look at three examples and compare them using market value pricing:
The Insurance Company vs. Building Contractor
Let's say you buy a new home for $200,000. Before your insurance company can set a premium, they'll need to know how much it would cost to build your replacement home. After calculating the costs of labor and materials, your local building contractor will then prepare an estimate for you.
Afterward, each insurance company will price their policy on the basis of market value pricing -- not replacement cost -- in order to make sure that they're still making money on you as a customer. The result is that your insurer could pay considerably less than what it actually costs your builder to rebuild the house; this is why some insurance companies will ask for a refund of their profit when setting up their policies.
The Insurance Company vs. Used Homes
If a fire damages your $200,000 home, then you'll likely get a payout that's comparable to the market value of similarly-sized homes in your region. However, if you were to buy an older home and then have it destroyed by a weather event, your insurer might offer less than the market value because of its age and condition. This is because your house would not cost as much to replace when accounting for one that's similar to yours in terms of both size and age; this is due to both buyer demand and availability.
The Insurance Company vs. Your Home
As you can see, the market value of your home is based on its size and condition -- this means that it's likely to fluctuate a lot as they are subject to change. If your home was replaced with one of the exact same size and condition as yours, then it'd cost a lot less than an insurance company would charge because of how much material they'd have left over.
In other words, market value pricing is arguably less fair than replacement cost pricing because it might not account for the unique value of what you own; you should consider looking into replacement cost pricing even if your insurer uses market value instead.
The economic value of your home might not always be the same as it was when you bought it, which is why it is important to look into replacement cost pricing even if your insurer uses market value instead. Just like with markets themselves, you can't always trust that market value pricing will always be accurate -- this means that every homeowner needs to know what they're entitled to and make sure they understand your policy before paying a single dollar.
Pricing Your Home For Market Value
Market value pricing means that your insurer will base their payment on what an insurance company would pay for similar homes in a particular region. Remember that market value is a number based on a variety of factors, not just the cost to rebuild your home, so it's important to understand exactly what this means.
Your local housing market is constantly changing in terms of how much homes cost and how many people want to buy them. For example, if you live in a city in an area where housing prices are fairly consistent between builders and neighborhoods while the surrounding suburbs are highly price-competitive for new homes, then your insurer might have trouble pricing your policy on an accurate basis because they don't know how much it will cost to replace your home.
In these situations, their estimate is likely to be based on market value numbers instead. However, if the housing market crashed and the city you live in no longer had any homes on the market, then your insurer might see a huge dip in the number of sales -- this means that they could offer you much less than market value.
It's also worth mentioning that insurers are required to look at similar homes in your region when sizing up your policy; they can't just look at houses for sale in distant neighborhoods. This means that there might be a big difference between what your insurer says your home is worth and its actual value -- since they'll need to find comparable homes nearby. But, this is why it's important to choose an insurance company that's easy to talk to and willing to answer your questions patiently.
Conclusion
Market value pricing works best for homeowners who want to avoid having to pay too much out of pocket. Keep in mind that market value pricing might not be the most accurate because it doesn't account for the unique value of your home, and your insurer might need additional time to research how much it would cost to build a replacement.
If you really want an accurate estimate from your insurer, then you should consider getting replacement cost pricing instead. However, keep in mind that there's no guarantee that the number they quote you is what the final payout will be -- so make sure you're clear about what your insurance policy includes before making any payments or signing on the dotted line.