Here’s a frequently asked insurance question that I get quite often: Why is my house insured for a different amount than what I paid for it and its bank-appraised value?
Your purchase price should equal market value when you buy a house. The bank-appraisal confirms that so if you default the bank can foreclose, sell the house at market value and recover their mortgage proceeds. The bank doesn’t care if your house burns down as long as you have adequate insurance.
In the event of a loss your insurance company has agreed to rebuild your house, not just write a check for market value. So your house is not insured at market value, it’s insured at current replacement cost. In calculating current replacement cost, the insurance company excludes the value of your land and estimates how much it would cost to rebuild your house today. Current replacement cost can be different and generally higher than market value for a number of reasons:
- If a new home, your purchase price may reflect a deal from the builder relative to construction cost.
- If a previously occupied home, your purchase price will reflect general trends in real estate prices since its construction unrelated to construction costs. For example, houses purchased right after the crash generally have market prices well below construction costs.
- The cost of construction labor and materials goes up over time at a different rate than the market appreciation/depreciation of your house.
- When your house was built it was likely part of a multi-home project where the builder received significant volume discounts on labor and materials which he built into the sales price. If your house needed to be rebuilt, those volume discounts would not be available.
In the residential real estate market over the last eight years, replacement cost has been generally higher than purchase prices. When purchase prices begin exceeding replacement costs, you will see a lot more new houses being built.