We call it gap insurance. Maybe that's misleading.
Questions received by CarInsurance.com show that there is a huge misconception about what gap insurance really covers. Many car owners believe gap insurance is a catch-all policy that makes their car payments anytime they're unable to. That is not the case.
Gap insurance does not cover:
- car payments in case of financial hardship, job loss, disability or death
- repairs to your vehicle
- the value of your car or balance of a loan if your car is repossessed
- a rental car while your vehicle is in the shop
- the diminished value of your car after an accident
- a down payment for a new car
- carry-over balances on any loans you rolled over into your new car loan
- extended warranties you add to your car loan
In short, gap insurance isn't "super coverage" that protects you if you don't have the best auto insurance coverage or can't pay on your loan.
What does gap insurance do? It pays the difference, in the event of a total loss, between what you owe on the car and what it is worth in an insurance company's eyes. That's it.
But that's a bigger deal than you might think.
When you need gap insurance, and why
According to Edmunds.com, the average new car depreciates 11 percent as soon as it leaves the dealer's lot. After a year, it's worth 20 percent less than new.
If you didn't put much down and had your taxes and licensing fees rolled into your loan, you could be upside-down (owe more than car's worth) before you are a block from the dealership.
For instance: You buy a car that stickers for $24,000 and rolls out the door with taxes and fees for $26,500. You put down only $1,000, sign your financing papers, get a car insurance policy and drive off the lot.
Nearly a year later, your "new car" is totaled out. You file a collision claim with your insurer and find out that the actual cash value of your vehicle is only $19,200. This means after your $500 deductible is taken out, your car insurance company will pay out $18,700 to your lienholder.
You still owe $23,500 on the car, so you're left with a "gap" of $4,800.
With a gap insurance policy that includes coverage for your deductible, this whole amount would be covered. If you didn't get gap insurance, you're left paying the difference out of your own pocket for a car you no longer have – and that hurts, because you've got to buy another car, too.
Gap is actually an acronym, meaning "guaranteed auto protection" or "guaranteed asset protection." Its function is to provide protection in the early years, when the loan exceeds the value of the car.
Where to buy gap insurance, and should you?
Gap insurance can be purchased from the dealership, your financing institution, some car insurance companies or a stand-alone gap insurance provider. If you have a lease, gap insurance may have been added automatically into the leasing contract.
Gap insurance is usually offered when you sign your loan documents and can be incorporated right into the purchase paperwork. When you buy it in this manner, the gap insurance charge is typically a flat premium of around $500 to $700.
Liz Weston, a credit expert and personal finance columnist at MSN Money, says buying from the dealer is not necessarily a good idea. "Gap is most expensive if you buy it at the dealership, because it goes in the loan and is then plus interest," Weston notes.
Check with your own auto insurer first for cost and availability. Costs vary due to insurance companies' different rating systems, but typically gap insurance is calculated as being 5 percent to 6 percent of your physical damage coverage costs. If your collision and comprehensive costs are $500, gap insurance coverage will add around $25 to your overall premium.
By checking also with stand-alone gap insurance providers, you can compare the cost of coverage. Before purchasing through a stand-alone gap provider, Weston recommends checking with A.M. Best or another rating service to make sure that the gap insurance company is stable and reputable.
Is gap insurance for you? "Probably, yes," Weston says. "Unless you have money sitting in the bank to pay off the balance of your loan above the car's worth, which most people don't, gap insurance would be necessary."
Weston believes those who are underwater on their loan and have little savings need gap coverage the most. She says car owners who don't put 20 percent down on a car or who have a loan longer than four years are probably underwater, making gap insurance worth buying.
If you don't know how underwater you are, check with Edmunds and Kelley Blue Book to find out the worth of your vehicle. To find a reasonably accurate value for your car, pick a point in the middle of the trade-in and private sales amounts.