What Is Gap Insurance And How Does It Work?

Gap insurance is an optional car insurance coverage that helps pay off your auto loan if your car is totaled or stolen and you owe more than the car’s depreciated value. Gap insurance may also be called “loan or lease gap coverage.”

This type of coverage is only available if you’re the original loan or leaseholder on a new vehicle. Gap insurance helps pay the difference between the depreciated value of your car and what you still owe on it.

Gap insurance is a type of auto insurance that car owners can purchase to protect themselves against losses that can arise when the amount of compensation received from a total loss does not fully cover the amount the insured owes on the vehicle’s financing or lease agreement.

This situation arises when the balance owed on a car loan is greater than the book value of the vehicle.

BREAKING DOWN GAP INSURANCE

As an example of gap insurance at work, consider John’s car, which is worth $15,000. However, he still owes a total of $20,000 worth of car payments. If John’s car is completely written off as a result of an accident or theft, his car insurance policy will reimburse him $15,000.

Because John owes the car financing company $20,000, however, he will still be $5,000 short, even though he no longer has a car.

If John purchases gap insurance, the gap insurance policy would cover the $5,000 “gap,” or the difference between the money received from reimbursement and the amount still owed on the car.

WHY DO I NEED GAP INSURANCE?

If you’re leasing or financing a new car, many lenders require you to have collision and comprehensive coverage on your car insurance policy until the car is paid off.

Gap insurance is meant to be used in conjunction with collision coverage or comprehensive coverage. If you have a covered claim, your collision coverage or comprehensive coverage would help pay for your totaled or stolen vehicle up to its depreciated value.

According to the Insurance Information Institute (III), when you drive a brand-new vehicle off the lot, its value immediately decreases. And, most vehicles’ values depreciate by about 20 percent in the first year of ownership.

But, what if you still owe more on your loan or lease than the vehicle’s depreciated value? That’s where gap insurance may help.

WHEN YOU MIGHT NEED GAP INSURANCE

Gap insurance coverage may apply if you’re underwater on your auto loan (meaning, you owe more than the car is worth) when your vehicle is stolen or totaled. “Totaled” means that repair costs exceed the value of the vehicle. Whether a vehicle is declared totaled depends on state laws and your insurer’s discretion.

HOW DOES GAP INSURANCE WORK?

Here’s an example of how gap insurance may work: Say you bought a brand-new car for $25,000. You still owe $20,000 on your auto loan when the car is totaled in a covered collision.

Your collision coverage would pay your lender up to the totaled car’s depreciated value, so let’s say it’s worth $19,000. If you don’t have gap insurance, you would have to pay $1,000 out of your own pocket to settle your auto loan on the totaled car. If you have gap insurance, your insurer would help pay the $1,000.

Keep in mind that, in the above scenario, the car insurance reimbursement goes completely to your auto lender to pay off a car that’s no longer driveable. If you think you would need help buying a new car after yours was totaled, you might want to consider purchasing new car replacement coverage.

Some insurers sell loan/lease gap coverage and new car replacement coverage together, as a single add-on to a car insurance policy for a brand-new vehicle.

CAN YOU GET GAP INSURANCE AFTER YOU BUY A CAR?

You may be able to get gap insurance after you buy a car, depending on the model year of the vehicle. Gap insurance isn’t just sold at car dealerships—many insurers offer it as part of a car insurance policy. And, according to the III, buying gap coverage from an insurance company often costs less than buying it from a car dealership.

Some insurers require your vehicle to be brand new in order for you to purchase gap insurance. That may mean:

  • That you are the original owner of the vehicle (you have the original lease or loan on the vehicle)
  • That the vehicle is not older than two or three model years

Check with your insurer to see what qualifications are required for you to buy gap insurance.

SITUATIONS FOR GAP INSURANCE

  • You financed a car and made little or no down payment: Without making a significant down payment, you’ll be upside down in your auto loan the moment you drive off the lot. It may be several years before the loan amount and the car’s actual value amount begin to balance.
  • You’ve traded in an upside-down car: When trading in an upside-down car, the dealership will add what you still owe to the loan balance of the new car unless you pay that difference up front. This extra balance could come back to haunt you if your car is totaled or stolen.
  • You bought a car with bad resale value: If you bought a car that quickly loses value, you’d probably be upside down without a substantial down payment. When we say substantial, think 25% or more.
  • You plan to put miles on quickly: Very few things reduce a car’s value faster than lots of driving. The faster you rack up the miles, the faster you depreciate your car’s value, and it’s likely that you’ll be dropping the value of your car more quickly than your payments can keep pace.
  • You’ve taken out a car loan with a long term (more than 60 months): A long-term loan takes longer than usual to hit the break-even point, which is when your loan balance and the car’s value begin to equalize.

IS GAP INSURANCE WORTH IT?

If you’re considering buying gap insurance, it’s important to remember that this type of coverage may only be available if you’re leasing or financing a new vehicle. Then, think about how much you owe on your auto loan versus the value of your car.

(You can get an estimate of what your car is worth by checking a site like Kelley Blue Book.) Do you owe more than your car is worth? Could you afford to pay the difference out of pocket if your car is totaled?

According to the III, you may want to consider gap insurance in the following situations:

  • If you made less than a 20 percent down payment on your vehicle,
  • If your auto loan is 60 months or longer,
  • If you’re leasing a vehicle, especially a new vehicle, be aware that many lease contracts include gap coverage. Check yours to see whether you have coverage.

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