If you lease or purchase a new car with a loan, you might want to consider obtaining the extra financial protection known as gap insurance. In the event the vehicle is stolen or totaled in an accident, this specialized coverage pays the difference between what you owe on the loan and the compensation your primary insurer will offer you. For more on this, see Do Drivers Really Need Gap Insurance?

While gap insurance can be a good idea if eat up a lot of miles on the road or have a model that’s known to depreciate quickly, be careful about where you buy it. The dealership may try to sell you its own policy, but that is likely to end up costing a good deal more than going with an outside carrier.

Gap Insurance Basics

The idea behind gap insurance is to provide a safety net for drivers who are underwater on their loan – in other words, they owe more than the car would be worth on the used market.

Because cars lose a significant amount of value the moment you pull off the lot, having negative equity is actually quite common in the early years of a car loan. According to Edmunds.com, the worth of the average car drops by about 19% after just one year of driving. After the second year, it typically loses another 12%.  Unless you have a short-term loan, it can be difficult to keep the loan balance below the vehicle’s market value during these early years.

Gap insurance makes up for this shortfall. Let’s say you have a sedan that you bought for $30,000. A year later, you get into a major collision and the car is declared a total loss by the insurance company. With traditional coverage alone, the primary insurer will reimburse you for the “actual cash value” of the vehicle, which is $24,000. Unfortunately, you still owe $26,000 to the lender. If you have a gap policy, it will cover the remaining $2,000 to help you retire the loan. For more on this, see Get Up To Speed On Car Gap Insurance.

Know Your Options

Drivers who lease a car may have gap insurance built into their contract. But if it’s not included with the lease, or you’re purchasing the automobile with a loan, you can do some shopping around.

Experts say you’re generally better off going with one of the major insurance companies than getting it from your car dealer. Dealerships typically charge a flat fee between $500 and $700 for gap coverage – and it could go higher still if the premium is combined into the loan.

One place to start for a more competitive rate is the company that already insures your car. Several big-name insurers offer a variant of gap protection – including Esurance, Progressive and Nationwide.  Ordinarily, they’ll bill you between 5% and 6% of your collision and comprehensive premium. So if you pay $1,000 for these two components, gap coverage will amount to roughly $50 or $60 a year in addition.

Keep in mind that depreciation is most aggressive when cars are relatively young, so you may only need gap insurance for two or three years. When you go with a major insurer, you can usually cancel the policy once you start to build equity, thus lowering your bill. It’s a good idea to periodically check the NADA Guides or other valuation sources to make sure you’re not paying for coverage you don’t need.

Some specialty insurers also provide gap insurance.  If you choose to go this direction, just make sure the company has a strong financial rating from A.M. Best, as well as a favorable grade from the Better Business Bureau.

Some Policies Don't Cover the Full Gap

Perhaps the biggest caveat when price-shopping among different insurers is that not all gap policies are the same. For example, some companies, including Progressive, refer to their offering as “loan/lease” coverage.

The main distinction is that loan/lease policies put a cap on the payout. Typically, the company reimburses up to 25% of the car’s cash value at the time of the accident or theft. Most of the time, this won’t make a huge difference, except for those who are deep underwater on their loan.

As an example, say you crash an SUV that’s currently worth $20,000 and you still owe $30,000 on your car loan. Rather than pay the full $10,000 difference, loan/lease protection entitles you to just $5,000 (25% of the SUV's $20,000 cash value).

To be on the safe side, go over the policy details before taking out gap coverage, and ask a representative to explain exactly how the coverage works, with specific examples such as the one above.

The Bottom Line

Gap insurance plays an important role for drivers who have significant negative equity in their automobile. Just remember: It pays to shop around rather than blindly accepting what the dealer has to offer.