What is replacement cost anyway?
When buying a new home, buyers often ask why their home insurance coverage is higher than the price they paid for the home during purchase? It comes down to the definition of "Replacement Cost."
Replacement Cost = The cost to rebuild your home from the ground up. This can include:
Home Market Price = What you can sell your completed home and lot to someone else for. This includes the land value and liabilities that come with owning the home. Often it is different than replacement cost.
A fun set of examples to show where replacement cost can really get out of whack with your home's market price:
Scenario 1: Home Market Price $65,000, Replacement Cost $175,000
You bought a fixer-upper in an "up and coming" neighborhood. You are getting a great deal on the home and plan to improve it over time. However, if the home were destroyed by a fire tomorrow, the home insurance carrier is on the hook for rebuilding a new similar sized home. They know it will cost way more than $65,000. They estimate it takes $175,000 to rebuild your home from the ground up, so they require that level of insurance on your homeowners policy.
Scenario 2: Home Market Price $10,000,000, Replacement Cost $5,000,000
You are looking to buy a nice beachfront home in the Hamptons. It will cost you $10,000,000. However, the guy who sold it to you only paid $6,000,000 to build the home. He says the home is worth $10,000,000 because that stretch of land is worth $4,000,000 alone. If your home is wiped out by a massive hurricane, you won't need to rebuild the land, but only the house itself. You should be fine with home insurance coverage of $6,000,000. A full $4,000,000 difference from the market price of the home.
Scenario 3: Home Market Price $500,000, Replacement Cost $1,175,000
You bought a castle of a home made of beautiful solid stone and filled with solid oak floorboards. You got a great deal on it ($500,000!), as it is a bit remote and has been on the market for a while. While stone has gone out of style in modern homes, the insurance company still has to estimate what it would cost to rebuild your home "like for like" in the case the home is completely destroyed. The cost to get all those stones, and an expert mason who knows how to build a full structure (not to mention the solid oak) is going to cost over $1,000,000. Hence, your home's replacement cost is far above its market price.
Whether you are looking at a castle or dreaming of buying a home in the Hamptons, it is helpful to show just how different your home's market value can be from its replacement cost.
Hope that helps!
At your service,