What is gap insurance?

A shiny new car may seem appealing as you drive past the dealership—before the sticker shock and the reality of a new auto loan sets in, that is. Even if the initial price isn’t a concern, according to CARFAX, the value of a new vehicle can drop by more than 20 percent after the first 12 months of ownership. Everyone’s heard about how much a car depreciates as soon as it’s driven off the lot, but even after those first 12 months, cars lose 10 percent of their value annually for the following four years.

If you plan to own your vehicle for the long haul, depreciation may not be an issue for you. But if you like to change vehicles relatively often, gap insurance may be something to consider. Gap insurance could save you thousands of dollars if your car is totaled, either from an accident or from theft.

Gap insurance is a type of optional (add-on) car insurance. If purchased, it protects owners against losses that may occur if the compensation from a total loss doesn’t cover the outstanding amount owed on a vehicle’s financing or lease agreement. If a car is totaled or stolen, gap insurance pays for the difference between the vehicle’s value and the loan or lease balance. Contrary to popular belief, “gap” doesn’t refer to that price disparity. It’s an acronym that stands for “guaranteed asset protection.”

What does gap insurance cover?

In the early years of owning a new car, the loan amount may exceed the vehicle’s market value. Gap insurance covers the difference between what a car is worth at the time of total loss (the depreciated value) and the amount you still owe.

How gap insurance works

Standard auto insurance policies typically only cover the current market value of the vehicle at the time of a claim. Gap insurance is meant to supplement collision or comprehensive coverage.

Let’s say you bought a brand-new vehicle for $36,000, and a year later, your car is totaled in a covered collision. Assuming you’ve been making your monthly payments, you most likely still owe around $30,000 on your loan. At the same time, as we mentioned, the car’s value may have dropped as much as 20 percent in the first 12 months, making it worth $28,800 at the time of the collision.

Standard car insurance would pay your lender up to the car’s depreciated value—in this case, only $28,800. That means you must pay $1,200 out of pocket to settle the auto loan. However, if you have gap insurance, your insurer would help pay that $1,200.

When to get gap insurance

You may want to consider buying gap insurance in the following instances:

• You made a down payment of less than 20 percent.
• You negotiated financing terms of 60 months or longer.
• You’re leasing the car (some lease agreements require you to have gap insurance).
• You purchased a car that depreciates at a faster-than-average rate.
• You traded in your previous car and rolled negative equity into a new loan.
• You know you’ll add excessive miles to the car quickly—the more miles on your vehicle, the lower its value.

When to avoid getting gap insurance

Gap insurance is an additional fee on top of all the other bills you have to handle. So, you must evaluate if paying for this coverage is truly worth it. Here are some scenarios where gap insurance might not be worth it for you:

• Your down payment was 20 percent or more when you bought the car, so there’s a slight chance the car loan or lease balance will be less than the market value—even if it’s totaled in the first year. 
• Your loan or lease term is five years or less. 
• The car’s make or model typically holds its value in the market better than most, such as a luxury or sports car. 

Still trying to decide if gap insurance is right for you? There’s a simple step you can take to find out. Check the National Automobile Dealers Association (NADA) guide to see how much your car is currently valued on the market. Compare this to your loan or lease balance. If your car’s value is more than the balance, gap insurance isn’t necessary.

How to get gap insurance

There are a few ways to go about getting gap insurance. The most straightforward option is to go through your auto insurer and have it added as a portion of your insurance payment. For a one-time fee, you can go through the dealership, the lender or a company specializing in gap insurance. It’s wise to shop around, as rates differ between providers.

How much gap insurance costs

On average, gap insurance is about $61 a year on top of comprehensive and collision coverage. Some options charge a single fee between $500 and $700 for gap insurance. It’s worth noting that if you add gap insurance coverage to your loan, you’ll also pay interest on it.

Gap insurance alternatives

There’s an alternative to gap insurance called loan/lease payoff. Unlike gap insurance, loan/lease payoff covers just a percentage of your car’s value on top of the current market value—often around 25 percent. Several major insurance companies offer loan/lease payoff.

If you’re set on buying a brand-new car, gap insurance can be a lifesaver in the unfortunate scenario that your vehicle is totaled in the first few years of ownership. Even if a new car isn’t financially feasible and your credit isn’t where you’d like it to be, there are still ways to buy a car with a low credit score. That being said, if you have poor credit, you’ll likely pay higher insurance premiums and interest rates, so it may be worth working to improve your credit before making the big purchase.

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