Insurance can be complicated and lead to many questions. This is particularly the case when it comes to insuring your home. One of the essential things for a homeowner to understand is the difference between replacement cost and actual cash value. Many homeowners wonder which is better.
Let’s take a look at your home insurance options in terms of replacement cost versus actual cash value.
What Is Home Insurance?
Home insurance is the term used to refer to the insurance that covers your residence. This tends to involve two different policies, building insurance and contents insurance. When you own your own home, these two types of insurance are typically combined. You don’t need a full home insurance policy when renting.
What is buildings insurance?
Building insurance is a protection policy that covers the overarching structure of your home. This includes the foundation, roof, walls, ceiling, plumbing, electric, and certain fixtures. Building insurance is typically taken out for the amount that it would cost to completely rebuild your home.
What is contents insurance?
Meanwhile, contents insurance is the policy that will cover your general belongings such as furniture and personal items. Contents insurance is typically taken out for a maximum amount (sum-insured) or based on the number of bedrooms (bedroom-rated). They are paid out either in terms of replacement cost or actual cash value.
What is Replacement Cost?
Replacement cost is the amount that it costs to replace an item with a new one. If an item is damaged, replacement cost policies would provide you with money to replace it with a new item.
How Does Replacement Cost Work?
Let’s say you purchased a television that is damaged due to a water leak three years later. Replacement cost would pay out the amount it costs to replace that television with a similar one minus any excess. If you initially bought it for £500 and a new similar TV is £500, you will be paid that amount.
If the water leak damaged many items, the replacement cost will pay out the amount necessary to replace them all. This is as long as the total amount of personal belongings lost is less than the maximum amount covered by your policy.
If you do suffer water damage, here’s what you need to do to make a successful leak claim.
What is Actual Cash Value?
Actual cash value policies work differently than replacement cost policies. Actual cash value is an insurance policy that pays you the actual value that your items were worth at the time they were damaged.
This means that actual cash value policies must figure in the initial value of the item while taking into account depreciation, which is the loss of value in an item as it ages. Thus, actual cash value policies will pay you less than the initial value of an item.
How Does Actual Cash Value Work?
When trying to understand how actual cash value works, you will note that computing your insurance coverage requires a few more steps. Actual cash value works by taking into consideration the depreciation of the insured items. Let’s take a look at an example.
Consider the purchase of a television set for £500 again that is damaged during a water leak. If the depreciation rate for televisions is 7% per year, the total depreciation for three years will be £105 (£35 per year). Therefore, the actual cash value insurance policy would pay you a maximum of £395 for a new television.
Which is Better: Replacement Cost or Actual Cash Value?
When deciding whether replacement cost or actual cash value is better, the answer boils down to your personal preference and comfort with risk.
Actual cash value policies tend to have cheaper premiums; however, they will not provide you with enough money to completely replace all of your losses. Meanwhile, replacement cost policies will have higher premiums but will fully protect you in a loss, providing you with the actual amount needed to replace lost items with new ones (minus your excess).
While an actual cash value policy will result in slightly lower premiums, most people tend to prefer the security provided with a replacement cost policy. Thus, replacement cost tends to be the favoured way to go, particularly if you are seeking peace of mind.
James Banerjee is an Account Director who graduated from the University of Kent in 2014. He works in SEO on clients such as HSBC UK and Nestle and he has a keen interest in personal finances and money-saving advice.