How Does Gap Insurance Work?

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Gap insurance is a form of coverage that pays the difference between the balance you owe on a car and your auto insurance payout on a total loss. The timing of purchase and specific benefits from this protection impacts whether it makes sense to buy it.

Gap Coverage Basics

  • Though normally referred to as "gap insurance," this type of protection is actually a debt cancellation agreement, according to the legal website Nolo. It doesn't insure your property in the traditional sense of insurance. Instead, when you pay for protection, you get a guarantee of auto loan payoff on a total loss. This structure makes gap useful only when you are underwater on a loan. If you owe $14,000 and the car insurer pays $12,500 on a total loss, your gap protection covers the remaining $1,500 you owe the lender.

Buying Gap

  • You have a couple options when purchasing gap protection. One is to buy coverage through the dealer. The other is to purchase a plan on the open market, just as you do with auto insurance.

    Gap insurance normally costs just $20 to $30 per year when included with a full auto coverage policy, according to Bankrate. However, some car buyers falsely believe they have to buy this protection through the dealer. In fact, the most affordable gap coverage is available from a typical insurance company. You can buy it at any point; not just at the time of purchase.

When to Buy

  • Gap insurance typically has no value if you buy a used vehicle and put money down. For example, say you buy a used car with a market value of $15,000 and put $3,000 down, leaving an initial loan balance of $12,000. In this case, your car is likely worth more than your balance even after you drive it for a short while.

    When buying a new car, gap coverage often makes more sense. A new car loses a percentage of its value the minute you drive it off the lot and turn it into a "used" car. Thus, with little or no money down on the purchase, it is common for a new car buyer to start out with negative equity. This means gap insurance is worth a few thousand dollars or more if you total a new car fairly soon after purchase.

Other Factors to Consider

  • Research on the normal depreciation rate for a vehicle helps when deciding on gap. Cars depreciate at varying rates, with some losing up to 30 percent of their value within a few months, according to Nolo.

    A longer loan term with smaller monthly payments contributes to the need for gap, since the loan is repaid slowly. Your total purchase amount include taxes, registration and other fees, that extend your borrowing amount at the time of purchase. Some companies require you to carry gap coverage when leasing a vehicle.

References

  • Photo Credit simonkr/iStock/Getty Images
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