What is gap insurance and how does it work?

Mr. Helalul Mubin

Jan 18, 2024

Introduction

If you have a car loan or lease, you may have heard of gap insurance. But what is it exactly, and how does it work? Gap insurance is a type of optional car insurance coverage that can protect you from paying out of pocket if your car is stolen or totaled. In this post, we will explain the basics of gap insurance, how it works, when you need it, where to get it, how much it costs, and some common myths and tips about it.

The Basics of Gap Insurance

Gap insurance stands for guaranteed asset protection. It is designed to cover the difference between what your car is worth and what you owe on it in case of a total loss. A total loss means that your car is either stolen or damaged beyond repair.

Definition and Purpose

Gap insurance is meant to bridge the gap between your car's value and your loan or lease balance. This gap can occur because cars tend to depreciate faster than you pay off your loan or lease. According to Carfax, a new car can lose more than 10% of its value in the first month and more than 20% in the first year. After five years, a car can lose more than 60% of its value.

If your car is totaled or stolen, your regular car insurance will only pay you the actual cash value (ACV) of your car at the time of the loss. The ACV is the market value of your car minus depreciation and wear and tear. However, the ACV may be lower than what you still owe on your loan or lease. This means that you will have to pay the difference out of your own pocket, unless you have gap insurance.

Coverage Scenarios

Gap insurance can apply in various situations where your car is totaled or stolen and you have a loan or lease. Here are some examples:

You bought a new car for $30,000 and financed it with a 60-month loan. After one year, your car is worth $24,000, but you still owe $27,000 on your loan. If your car is totaled in an accident, your regular insurance will pay you $24,000, minus your deductible. You will have to pay the remaining $3,000, plus your deductible, to your lender. Gap insurance can cover the $3,000 gap for you.
You leased a new car for $25,000 and paid a $2,000 down payment. After two years, your car is worth $18,000, but you still owe $21,000 on your lease. If your car is stolen, your regular insurance will pay you $18,000, minus your deductible. You will have to pay the remaining $3,000, plus your deductible, to your leasing company. Gap insurance can cover the $3,000 gap for you.

How Gap Insurance Works

Gap insurance works in conjunction with your comprehensive and collision coverage. These are the two types of car insurance that cover damage to your own car, whether it is caused by an accident, fire, vandalism, or theft. You need to have both comprehensive and collision coverage in order to buy gap insurance.

Exploring real-life examples

To illustrate how gap insurance works, let's look at two real-life examples of gap insurance claims.

Scenario 1: Vehicle Depreciation

John bought a new car for $35,000 and financed it with a 72-month loan. He paid a $5,000 down payment and got a loan for $30,000. He also bought comprehensive, collision, and gap insurance for his car. After three years, his car was worth $20,000, but he still owed $23,000 on his loan. One day, he got into a severe accident that totaled his car. His regular insurance paid him $20,000, minus his $500 deductible. He still had to pay $3,000 to his lender. Fortunately, his gap insurance covered the $3,000 gap for him.

Scenario 2: Total Loss Accident

Lisa leased a new car for $28,000 and paid a $3,000 down payment. She also bought comprehensive, collision, and gap insurance for her car. After one year, her car was worth $22,000, but she still owed $25,000 on her lease. One night, her car was stolen and never recovered. Her regular insurance paid her $22,000, minus her $500 deductible. She still had to pay $3,000 to her leasing company. Luckily, her gap insurance covered the $3,000 gap for her.

Factors Influencing Gap Insurance

The amount of gap insurance you need and the cost of gap insurance depend on several factors, such as:

Loan terms and conditions: the longer your loan term, the higher your interest rate, and the lower your down payment, the more likely you are to have a gap between your car's value and your loan balance. This means that you may need more gap insurance and have to pay more for it.
Depreciation rates: The faster your car depreciates, the bigger the gap between your car's value and your loan balance. This means that you may need more gap insurance and have to pay more for it. Some factors that affect depreciation rates are the make and model of your car, the mileage, the condition, and the demand.
Comprehensive insurance coverage: The higher your comprehensive insurance deductible, the lower your regular insurance payout in case of a total loss. This means that you may need more gap insurance and have to pay more for it.

Do You Need Gap Insurance?

Gap insurance is not mandatory, but it can be a smart choice for some drivers. You may need gap insurance if:

You have a loan or lease on your car.
You have a high loan-to-value ratio (the percentage of your car's value that you borrow).
You have a long loan or lease term (more than 48 months).
You have a high interest rate on your loan or lease.
You have a low or no down payment on your car.
You have a car that depreciates quickly.
You drive a lot of miles per year.

You may not need gap insurance if:

You own your car outright.
You have a low loan-to-value ratio (less than 80%).
You have a short loan or lease term (less than 36 months).
You have a low interest rate on your loan or lease.
You have a high down payment on your car (more than 20%).
You have a car that depreciates slowly.
You drive a few miles per year.

Where to Get Gap Insurance

You have several options for obtaining gap insurance, such as:

Your car dealer or lender: You can buy gap insurance from the same place where you buy or lease your car. However, this may be the most expensive option, as dealers and lenders may charge higher premiums and fees. They may also roll the cost of gap insurance into your loan or lease, which means you will pay interest on it.
Your car insurance company: You can buy gap insurance from your regular car insurance provider. This may be a cheaper and more convenient option, as you can bundle it with your other car insurance coverage and pay one bill. However, not all car insurance companies offer gap insurance, and some may have eligibility requirements, such as the age and mileage of your car.
A standalone gap insurance provider: You can buy gap insurance from a separate company that specializes in gap insurance. This may be a more affordable and flexible option, as you can shop around for the best deal and coverage. However, you may have to deal with two different claims processes if you have a total loss: one with your regular insurance company and one with your gap insurance provider.

Cost of Gap Insurance

The cost of gap insurance varies depending on several factors, such as:

The value of your car.
The amount of your loan or lease.
The length of your loan or lease term.
The depreciation rate of your car.
The deductible of your comprehensive insurance.
The provider of your gap insurance.

According to NerdWallet, the average cost of gap insurance from a car insurance company is about $20 per year. However, the cost of gap insurance from a dealer or lender can range from $400 to $700 as a one-time fee. The cost of gap insurance from a standalone provider can vary depending on the provider and the coverage.

Comparing Costs with Potential Benefits

To decide whether gap insurance is worth it for you, you should compare the cost of gap insurance with the potential benefits. You can estimate the potential benefits by calculating the gap between your car's value and your loan or lease balance at any given time. You can use online tools, such as Kelley Blue Book, to find out your car's value and depreciation rate. You can also use online calculators, such as [Bankrate] or [Cars.com], to find out your loan or lease balance and payments.

For example, let's say you bought a new car for $30,000 and financed it with a 60-month loan at 5% interest. You paid a $3,000 down payment and bought gap insurance from your car insurance company for $20 per year. After one year, your car is worth $24,000, but you still owe $26,000 on your loan. If your car is totaled in an accident, your regular insurance will pay you $24,000, minus your $500 deductible. You will have to pay the remaining $2,000 to your lender. Gap insurance will cover the $2,000 gap for you. In this case, the cost of gap insurance for one year is $20, and the potential benefit is $2,000. Therefore, gap insurance is worth it for you.

However, as you pay off your loan and your car depreciates, the gap between your car's value and your loan balance will shrink. Eventually, you may reach a point where you owe less than what your car is worth. At this point, you may not need gap insurance anymore, as your regular insurance will cover the full amount of your loan in case of a total loss. You can cancel your gap insurance at any time, but you may have to pay a cancellation fee or get a prorated refund, depending on your provider.

Tips for Cost-Effective Gap Insurance

To get the best deal on gap insurance, you should:

Before choosing a provider, look at the different quotes and options they have.
Negotiate the price and terms of gap insurance with your dealer or lender.
Avoid rolling the cost of gap insurance into your loan or lease.
Review your policy periodically and cancel it when you no longer need it.

Common Myths About Gap Insurance

Gap insurance can be confusing and misunderstood by many drivers. Here are some common myths and facts about gap insurance:

Myth: Gap insurance covers everything.
Fact: Gap insurance only covers the gap between your car's value and your loan or lease balance. It does not cover other expenses, such as your regular insurance deductible, your loan or lease payments, your rental car fees, or your medical bills. You may need other types of insurance or coverage to pay for these costs.
Myth: Gap insurance is mandatory.
Fact: Gap insurance is optional, unless your dealer or lender requires it as a condition of your loan or lease. However, even if they do, you do not have to buy it from them. You can shop around and choose your own provider.
Myth: Gap insurance is the same as new car replacement coverage.
Fact: Gap insurance and new car replacement coverage are different types of coverage. Gap insurance pays the difference between your car's value and your loan or lease balance. New car replacement coverage pays the cost of buying a new car of the same make and model as your totaled car. New car replacement coverage may be more expensive and have more restrictions than gap insurance.
Myth: Gap insurance lasts for the entire duration of your loan or lease.
Fact: Gap insurance lasts as long as you need it, which may not be the entire duration of your loan or lease. You can cancel your gap insurance at any time, as long as you do not have a gap between your car's value and your loan or lease balance. You should review your policy regularly and cancel it when you no longer need it.

Tips for Maximizing Gap Insurance Benefits

To make the most of your gap insurance, you should:

Be aware of what your policy entails and what it excludes by examining it closely.
Notify your insurer as soon as possible if you have a total loss.
Keep all the documents and receipts related to your loan or lease and your car insurance.
Follow the claim processes for both your regular insurance and your gap insurance.
Cooperate with your insurers and provide them with the information they need.

Conclusion

Gap insurance is a type of optional car insurance coverage that can protect you from paying out of pocket if your car is stolen or totaled. It covers the difference between your car's value and your loan or lease balance. Gap insurance can be a smart choice for some drivers, especially those who have a high loan-to-value ratio, a long loan or lease term, a low down payment, or a fast-depreciating car. However, gap insurance is not mandatory, and you may not need it for the entire duration of your loan or lease. You should compare the cost and benefits of gap insurance with your personal financial situation and car depreciation rate. You should also shop around and choose the best provider and policy for your needs. Gap insurance can give you peace of mind

and save you money in case of a total loss, but it is not a substitute for other types of insurance or coverage that you may need.