Taking out a loan to finance your car is slightly risky because cars start depreciating in value immediately after they leave the parking lot. If your vehicle gets caught up in an accident or stolen, your insurance company would only reimburse you up to the current depreciated value of the car, which is way lower than the auto loan amount used in buying the car.
Let’s say, you took out an auto loan of $30,000 to buy a car. Five years later, the value of the car drops to $23,000. You got in an accident.
Your insurance company pays you for the current depreciated value of the car which is $23,000. How on earth are you going to pay the remaining $7000 to settle your auto loan of $30,000?
That’s where gap insurance comes in.
But, how does it work? We’ll go over that in this article and answer other pressing questions about gap insurance.
Related: How Do I Find Out If My Car Is Insured?
What is gap insurance?
Gap insurance is an optional auto coverage that settles the difference between the amount on your auto loan and your car’s depreciated value at the time it’s stolen or totaled.
The difference between what you owe on your auto loan and your car’s value happens because most cars start losing value as soon as you buy them.
By the time your vehicle gets damaged in an accident some years later, there would be a natural ‘gap’ between your auto loan and your car’s diminished market value.
Your loan would be higher than your car’s present worth and your insurance company would only payout the value of your car’s current worth, leaving you stranded paying for your outstanding loan balance.
Gap insurance saves you years of paying a loan for a damaged car that you can no longer drive.
How does gap insurance work?
Here’s a simple breakdown of how gap insurance works.
You take out a loan of $50,000 to finance your car. Three years later, the car’s value depreciates to $45,000.
Suddenly, your car gets hit by a truck driver and experiences untold damage.
Your auto insurance company would look into your collision coverage and payout the current value of your car, which is $45,000, minus your deductible of $500.
So, your insurance company removes your $500 deductible and pays $44,500 to your auto lender while you take care of the deductible.
What happens to the remaining $5000 that you’ll pay to your car lender to settle your loan of $50,000?
Your gap insurance comes to the rescue. The gap insurance is released to cover the remaining $5000 and complete your car loan.
That way, you won’t be stuck paying $5000 even when you’re unable to use your faulty car.
Related: How Does Car Insurance Deductible Work?
When do I need gap insurance?
These are instances when you’ll profit from gap insurance.
If your car depreciates really fast
Some cars depreciate faster than others. Luxury cars are one example of that, but there are others.
One way to estimate the depreciation of cars is to look up any make and model you’re about to buy on Edmunds car depreciation calculator.
You can see how far a car will depreciate in a year.
You make a down payment below 20% for the car
A little down payment means you possess little equity in the car.  A low down payment also implies that you’re likely to pay more to complete your loan if your car gets totaled in an accident.
It puts you in dire need of a gap insurance to save the day, in the event of car theft or accident.
Your car is leased
Many auto lease companies would automatically work gap insurance into your lease so you’ll be able to pay up when things go sour.
If your lessor doesn’t add gap insurance, it’s smart to sign up for gap insurance with an auto insurance company in case your car is stolen or damaged.
Rollover from other loans
If you’ve rolled over your loans from previous auto finances to your present car loan, you’ll likely end up needing gap insurance to cover your increased auto loan down the line.
Your car loan exceeds five years
The longer your car loan lasts, the more your car depreciates. And if it goes past five years, there’s a good chance of a sizable gap between your car’s depreciated value and your auto loan if you’re involved in an accident.
The average auto loan term stands between 72 months and 84 months, that’s between roughly 5 to 7 years.
If you fall into this statistic, you’ll seriously need gap insurance to remedy or cushion the effects of your car getting totaled after an accident.
Will gap insurance pay off my loan?
Gap insurance pays off the remaining loan balance when your car’s reduced market value is subtracted from your auto loan amount.
It doesn’t pay off your entire car loan.
In an ideal world where cars don’t lose value when bought, your car insurance, such as comprehensive or collision insurance should completely cover the cost of your auto loan if your car is involved in an accident.
If you financed a car for $25,000 and it gets an accident in the next three years, the car value would remain $25,000 in a perfect world.
And then, your auto insurance company would pay you the current market value of your car, which is $25,000. Easy peasy, right?
Well, this is an imperfect world.
Your car won’t maintain the same value in three years’ time. It’ll most likely drop to $22,000.
And then your insurance company would cover the cost of the car’s current value, which is $22,000, leaving the remaining $3000 for you to handle.
That’s when gap insurance pays off what’s left of your auto loan.
Also Read: How to Get a Car Insurance
What does gap insurance cover?
Gap insurance only covers the difference between your car’s current value and the outstanding loan balance on your car.
What doesn’t gap insurance cover?
The following items are not covered by gap insurance:
- Car repair and replacement costs
- Auto insurance deductibles
- Down payments on car loans
- Outstanding balances of a rolled-over auto loan
- Extended warranties
- Engine failure
- Security deposits
- Default fee for high car mileage
Pros of gap insurance
- Settles the outstanding debt from your auto loan when your car’s current market value is paid for by your insurance company
- Doesn’t come with a deductible
- Saves you the trouble of paying a car loan for an unusable car
What are the cons of gap insurance?
- This could lead to higher loan interest if purchased through a car dealer
- Slightly increases the overall cost of your auto insurance coverage
Should you really get gap insurance?
You should consider getting gap insurance if your auto loan term is going to last for more than five years because the car’s market value is likely to have gone down significantly.
This could extend the difference between the car’s actual cash value and your outstanding loan amount. Gap insurance would come in handy in times like these, whenever your car gets totaled.
You should also think of getting a gap insurance if you’re leasing a vehicle or making a down payment below 20%.
How to buy gap insurance
You’re typically allowed to buy gap insurance only three years after your car’s purchase.
There are four ways to buy gap insurance:
- Through a car dealer: Buying gap insurance through a car dealer is the costliest option, as you’ll pay a higher interest rate compared to other options. Most car dealers automatically add gap insurance to your car lease, so do well to peruse your lease agreement.
- Through an auto insurance company: This is a cost-effective option of buying gap insurance. You can request your independent broker or agent to add gap insurance to your insurance policies after obtaining a quote.
- Through an auto finance lender: If you plan on financing a car, your lender can easily add gap insurance to your loan agreement.
- Through a company that exclusively sells gap insurance: Some companies only sell gap insurance. Reach out to them and purchase your gap insurance from them.
Before most auto insurance companies, car dealers, and auto finance lenders give you gap insurance, they need you to state that you’re the original owner of the vehicle and that the vehicle is less than three years old.
Related: How Do Insurance Companies Value Cars?
When should you cancel gap insurance?
You should cancel gap insurance when your auto loan has become less than your car’s current value.
You should also cancel gap insurance when you can afford to pay the difference between your remaining loan balance and your car’s current value out of pocket.
If you can settle your gap insurance cost from your personal savings, then you don’t need gap insurance.
Lastly, if you’re not on a car loan, feel free to drop your gap insurance.
Replacements for gap insurance
There are two alternatives or replacements for gap insurance. They are new car replacement coverage and better car replacement coverage.
New car replacement coverage
A new car replacement coverage supplies you the funds to replace your damaged car with a new car of the same make and model.
The funds aren’t equal to your car’s depreciated value, but the original value.
This coverage comes with a deductible, and most times your auto insurance company examines your current car’s age and mileage before qualifying you for a new car replacement coverage.
Better car replacement coverage
The better car replacement coverage replaces your faulty car with a car of a newer or better make and model. It is only available for auto insurance policyholders who own their cars, not those with leased cars.
If your car gets totaled in an accident, it would be replaced with a new model that’s one or three years newer.
Some car insurance companies charge you a deductible for better car replacement coverage.
Also Read: What Is a Car Liability Insurance?
