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, John's car insurance policy will reimburse him with $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.
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 percent 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.