When you buy your home insurance policy, it has different coverages — each with its own limit. To make sure you're fully insured, you need to understand how each limit works and what the limit on your policy is.
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The most important part of your home insurance policy is usually the structural coverage. That covers the cost of rebuilding after such events as fires or tornadoes. Remember that you may need separate coverage for floods or earthquakes. But once you have those coverages, those limits will usually work similarly to your structural coverage.
There are two different ways insurance companies set structural coverage limits. One is replacement cost, and the other is current cash value.
Current cash value covers the value of your home itself, not including the cost of the land. Since the parts of your home wear out over time, most homes have a lower cash value as the years go on. The increase in your property value is tied to the increase in land values. The problem with current cash value is that if something happens to your home, you need a new home or new parts but only get reimbursed for a fraction of the cost. For example, if your home has an expected lifespan of 30 years and is 25 years old, you might only get 5/30ths of what it's worth after subtracting 25/30ths for depreciation.
Replacement cost covers the actual cost of repairs. For example, if you need a new roof, the insurance company pays for a new roof. There is usually a limit on your replacement costs, based on an appraisal of your home when you buy your policy. If construction costs rise, you may still end up underinsured if you don't increase your coverage. If you opt for extended replacement cost, you get an additional percentage over the original replacement cost to guard against inflation.
As with your structural coverage, you can choose between current cash value and replacement cost. You usually pick a specific dollar limit based on how much stuff you own, and the insurance company will reimburse you up to that amount. When you make a claim, you will need to prove the value of what you lost. Be aware that certain items, such as jewelry and electronics, often have lower limits under your property coverage unless you get additional coverage specific to those items.