What Is Gap Insurance?
As you're probably aware, your new vehicle starts to lose value as soon as you drive it off the car dealer's lot. Your new car continues to depreciate every day so that you lose up to 30 percent of the car's value within its first year.
If you've ever been in an accident or had your car stolen, you know that your auto insurance pays you for the depreciated value of the vehicle — that is, the amount the vehicle is worth after all that depreciation. Given that the standard rate of depreciation is 17.8 percent per year (up to the sixth year of your car's life), that means you could be in trouble if that unfortunate accident or theft should occur.
Sure, your insurance company will reimburse you for your loss. That's why you have auto insurance, after all. But if you don't get your car back in driveable condition, either due to theft or because it was declared a total loss, the amount of reimbursement you receive may not be enough to cover the cost of a new vehicle. And if you're still making car payments, your compensation may not even be enough to pay off the auto loan or lease, putting you upside down on your car loan.
That's where gap insurance comes in. Gap insurance is a secondary form of auto insurance that's specifically intended to cover the gap between what your damaged or stolen car is currently worth and what it would cost to put you in the new model of the same vehicle.
Here's an interesting tidbit: While it would make sense that it's called "gap" insurance because it covers a financial gap, actually the "gap" in gap insurance stands for Guaranteed Asset Protection.
When you understand how gap insurance works, you can make smart decisions when you shop for it.
What Does Gap Insurance Actually Cover?
Gap insurance stands alongside your liability, comprehensive, and collision insurance to provide extra coverage, including the deductibles on your other insurance coverage. There may be a cap on the deductible amount your gap insurance will cover.
Also, it protects you against negative equity in your car. Let's say you buy a new car for $25,000. The moment you drive your car off the dealer's lot, it loses several thousand dollars in value, and it continues losing value as it gets older. If a year later, you're in an accident, and your car is declared a total loss, your insurance company might declare that your vehicle is worth only $18,000. If you actually still owe, say, $21,000 on the car, you're now upside down on your car loan.
What does that mean? Here's how it works. Your insurance company will make its reimbursement payment first to your credit union, bank, or the car dealer that loaned you the money to buy your car. That's because your bank or credit union is technically the owner of the vehicle until you've finished paying for it. If the insurance company's reimbursement payment doesn't cover the amount you still owe to your credit union or bank, then you're responsible for the rest. That's right: You don't have a car, you don't have money to buy a new car, and you actually owe money on the vehicle you no longer have.
Gap insurance steps up in this hypothetical example to help cover the $3,000 difference between the amount you owe on your car and the amount your insurance company will reimburse you for your loss, possibly including your entire deductible. Now you no longer owe any money to your old credit union or bank, and you're ready to start over without debt weighing you down.
Where Can You Buy Gap Insurance?
Your own auto insurance company is likely to sell gap insurance. Ask your insurance agent if you can add it to your existing insurance policy. Adding gap insurance will add a small amount to your regular insurance payment.
In many cases, the car dealership where you bought your new car also makes gap insurance available. Your lender may also offer gap insurance. In both these cases, your payment for gap insurance would be added to your monthly loan payments.
Also, some companies sell standalone gap insurance that becomes an add-on to your basic auto insurance policy. Check out the offerings from the Nationwide, American Family and Travelers insurance companies.
If you've financed your car through your insurance company, as is sometimes possible, you may be able to get gap insurance through your insurer. If you have your insurance through the AAA or State Farm, or if you're a veteran or active member of the military with insurance coverage through USAA, ask them what they offer in terms of gap insurance.
Buying gap insurance on a standalone basis may run you a flat fee of up to $300. That fee may go up to about $700 if you roll gap insurance into your loan. One of the least expensive ways to finance your gap insurance is to add it to your existing insurance policy, where you'll pay about $20 per year. Review your need for gap insurance each year, and cancel it if the numbers show you no longer need it.
Do You Need Gap Insurance?
If there's any chance that you might find yourself upside down on your car loan if your car is stolen or totaled, you should consider gap insurance. You're most likely to be in that position if your auto loan is a long-term one of five to seven years — and that's more common than it used to be. Experian points out that 66 months is the average term for a new car loan. And that means most people are likely to have negative equity in their cars at some point.
Take a look at your auto financing. Does it include other products such as dealer-installed options or an extended service agreement? Or did you roll debt from a previous car loan into your current loan? If so, your loan includes payments that aren't tied to the value of your car, and that makes it more likely that you could end up upside down in the event of a loss.
If you didn't make a down payment when you bought your car, you also stand a more significant chance of having negative equity if your vehicle is a total loss, since that down payment adds to your equity in the car.
Some new cars depreciate faster than others. If you have one of those makes or models, you could be surprised to learn that you're upside down. Check resources like the Kelley Blue Book or Edmunds to find out if you're driving one of these quick depreciators.
Your car also depreciates faster if you put a lot of miles on it each year. Think about getting gap insurance if you drive more than 15,000 miles per year.
Finally, gap insurance is a must-have if you lease your car rather than buying it. Some car leases require it. But check with your auto leasing company first, since many of them already include gap coverage.
When is gap insurance not worth it? If you own your car outright and have no loan, then your standard insurance should cover any total loss. Or if your loan is equal to the value of your vehicle, again, your insurance will pay off your lender in full, meaning you can skip buying gap insurance.