Get Up To Speed On Car Gap Insurance

Even if you have a fairly extensive auto insurance policy – complete with collision and comprehensive coverage – you may not be fully protected if your vehicle is stolen or totaled in an accident.

Here’s why. During the first few years of owning or leasing a car, many drivers are actually underwater on their loan – that is, they owe the lender more than the fair market value of the automobile. Remember, most cars take a huge depreciation in value the moment you drive them off the lot the day you purchase them. According to the car-buying site Edmunds.com, cars lose roughly 19% of their value after year one, and another 12% after the second year.

Here's how deep the depreciation can get in the first few years of owning your car.

Figure 1

The following chart shows the average rate of depreciation for new cars.

Source: Edmunds.com

If your ride needs to be replaced because of theft or a serious crash, the primary insurer only reimburses you for its current market value. Gap insurance – the letters stand for "guaranteed auto protection" – covers the difference.

Here's an example of how car gap insurance works: Suppose you buy a car for $25,000, with a small down payment and a $20,000 loan. After a couple of years, the car is completely wrecked in a highway collision. You still owe the bank the balance of the $20,000, even though the vehicle was worth only $17,000 at the time of the accident. The gap policy pays you the $3,000 shortfall to make good on the loan.

Worth the Added Expense?

Gap insurance isn’t worth the cost for everyone who buys a new car. The idea is to protect those who currently have negative equity – or could very soon because the car depreciates much faster than the owner's equity builds up as he or she repays the car loan. As a general rule, drivers who lease or put down less than 20% of the price when buying a car will want the added protection. In fact, many leases have a provision requiring you to sign up for gap insurance before you drive the car off the lot.

Obtaining this added protection is especially important if you finance a car for more than five years. A loan term this long makes it harder to build equity leaving you a much longer "underwater" period before it's safe to be without gap coverage. It’s also a good idea if you drive more than 15,000 miles a year or have a car that depreciates quickly.

Of course, if the difference between your car’s value and loan balance is small, you might be comfortable forgoing gap coverage altogether and paying the shortfall out-of-pocket if you end up needing to do so.

Another group that doesn't need gap insurance are those who paid all cash for their car and own it outright. If you don't have a loan, there is no gap to fill between what you owe the bank and what you get from your insurance company.

The extra coverage makes the most sense for people who can’t afford the potential hit – and it is mandatory for those who have to acquire it because of their lease. Paying for gap insurance will of course add to the monthly carrying costs of having your car.

How to Buy

There’s a good chance that the dealership will try to sell you gap insurance when you finance a new car. But keep in mind that you’ll probably find a better deal if you shop around on your own. Most insurance carriers offer gap protection and allow you to add it after you’ve bought the car, as long as you also have collision and comprehensive protection.

Typically, dealers will offer coverage for around $500 to $700 – plus interest, if the premium is built into the loan. When you buy directly from a carrier, on the other hand, you’ll usually pay between 5% and 6% of your collision and comprehensive insurance premium. Therefore, if you pay $1,000 for these two components, gap insurance might add an extra $50 or $60 to your bill.

You can also avoid unnecessary costs by dropping your gap coverage once you attain equity in the car. It’s worth it to periodically check your car’s value – NADAguides (a trademark of the National Auto Dealers Association) is a good source – and compare it to your loan balance.

The Bottom Line

If you lease a car – or buy one with a small down payment – gap insurance can provide a little extra peace of mind. However, if you’re only slightly underwater on the loan and can pay the difference out-of-pocket, this might be one form of insurance you can afford to do without. For more information, see Beginner's Guide To Auto Insurance and New Wheels: Lease Or Buy?