Gap Insurance for Your Car: Do You Need It?

Learn the basics of gap insurance -- what it is, who needs it,and how to buy it. 

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Gap insurance, more accurately called gap protection, covers the difference between what you owe on your car and how much the car is worth. Not everyone needs gap insurance (also called "totaled insurance"), however. Do you? Learn the basics of gap protection: What it is, who needs it, and how to buy it.

What is Gap Insurance?

For many drivers, a standard auto insurance policy provides enough protection to cover the cost of repairs or replacement if their car is damaged or stolen. However, if you total your car and the car's actual cash value is lower than the amount you owe on your loan balance or lease, that difference, or "gap," is not covered by insurance. Your insurance company won't pay out more than the car is worth (before it was damaged) -- so you will be responsible for paying that amount.

Gap protection -- which is often referred to as insurance, though it is actually a debt cancellation agreement -- is designed to cover this difference between auto value and auto loan. Before you pay for gap protection, though, consider how a gap occurs and how you can close it.

Why There's a Gap

Negative equity -- when your car is worth less than what you owe on it -- puts car buyers and lessees at risk because an auto insurance policy won't pay out more for repairs or replacement than the auto is worth.

Here's an example of how negative equity happens:

 Auto loan (5 years @6%):$25,000
 Loan balance (after one year):$20,580
 Car's actual value at time of loss:$19,000
           Insurance deductible:$500
 Amount insurance company pays:$18,500
 Gap (loan balance -- insurance payment):$2,080

Often, borrowers find themselves "upside down" (owing more than the auto is worth) through a combination of factors, including:

  • Taking out a loan with an extended term. A longer loan term not only means lower payments, it means you build equity in the vehicle much more slowly.
  • Depreciation. All cars depreciate, but some lose value much more quickly than others. According to some estimates, certain cars lose as much as 30% of their value within the first three months.
  • Putting little or no money down. If you finance all or nearly all the price of the car, you could be upside down as soon as you drive home, because a new car depreciates most at the moment it becomes "used."
  • Borrowing more than the purchase price. Borrowers who finance the tax, license, and registration, or extras such as service plans and extended warranties, will find themselves upside down before leaving the lot.

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