Now is as good a time as any to take a look at your car insurance coverage, but before you do, ask yourself a few questions. Do you lease your car, or are you still making payments on a loan for it? Do you know how much your car is worth relative to how much you still owe? If your car was wrecked tomorrow and it turned out you owed more on it than it was worth, would you be completely shocked? If yes, you should probably learn a little about gap insurance, which is designed to protect you (and your lender or leaseholder) if your car is totaled. Let’s look at the purpose of gap car insurance, who needs it and why, and how much it will cost.
Car Loans and Gap Insurance
To understand what gap car insurance is and how it works, it’s important to understand car insurance and car financing.
Car insurance is complicated because different types of insurance cover different problems. Furthermore, car insurance requirements vary from state to state, so you really need to talk to an insurance company to understand the bare minimum of coverage you’re required to carry where you live and exactly what you’ll be covered for if you get into an accident or damage your car in some other way. A one-car accident can be straightforward, but if there are multiple vehicles or other factors involved, it gets complicated quickly. You might not want to pay for several different kinds of car insurance, but if it turns out you need it, you’ll be glad you have it. What you pay for insurance depends on the types of coverage you have (liability, collision, comprehensive, gap, and others), what kind of car you drive, your deductible, and potentially other factors such as your age and driving record.
Having a lease or a loan instead of owning your car outright can also affect the kind of car insurance you need.
You can finance a car through the dealership or through your own bank or credit union, and you pay the loan back over a set number of months, with interest. The interest varies based on the rate you qualify for at the time you take out the loan. What you need to remember, as it relates to car insurance, is that when you borrow money to buy a car, the organization that lent you the money owns the car, not you, until you pay the loan in full. If someone steals the car or it's declared a total loss, the lender will still expect you to pay off the loan. Your car insurance will pay your lender instead of you, but if you don’t have sufficient insurance to cover the loss, you’ll have to pay the difference.
A car lease is similar in that you don’t actually own the car while you’re leasing it. Instead, you agree to make monthly payments to drive the car for a set period of time. When the lease is up, you can turn the car back in, as previously agreed upon, or you can buy the car outright for an amount specified when you signed the lease agreement. Again, if anything happens to the car, your car insurance payment will go to the company that holds your lease, not you.
Though loans and leases work differently, you’ll likely need gap insurance for at least the first few years of your loan and through your entire lease.
Loans with 60- or 72-month repayment periods are becoming increasingly common, and they contribute to the gap problem. If you’re making payments on your new car for five or six years instead of two or three, that increases the chance that something could happen to your car while you still owe money on it. And the longer you go before paying off your loan, the longer it will take before your equity in the car starts to reflect its actual value. Until that happens, you're underwater or upside-down on your car loan. That means that you owe more than your car is currently worth. This is also known as a gap.
There are many ways to end up underwater on a new car. For example, taking out a loan with no down payment, or a small one, means it will take longer than usual for the car’s value and your debt to equal out. Trading in a car that was underwater and rolling the old loan balance into the new loan is another common way people find themselves in this predicament. Being underwater on a car is common, especially right after you buy it, so it is essential that you protect yourself with gap insurance.
What Is Gap Car Insurance?
“Gap” is a handy word to explain the difference between what you owe on your car and what the car is really worth. However, “gap” is actually an acronym for “guaranteed asset protection.” That means that gap insurance guarantees or ensures that your lender or leaseholder will be protected for its asset – your car. Let’s look at how that works.
If your car is totaled, your insurance company will look at how it happened. If it was a collision, you’ll need collision insurance to cover it. In other scenarios (like a natural disaster, fire, or theft) you’ll need comprehensive insurance to receive compensation for the loss. Regardless of whether you lose your car to a collision or to another disaster, insurance will generally only pay for what the car is worth, minus your deductible. (Some insurance companies will pay a little more, like 10 percent over the value of your car, but that varies from company to company and is not especially relevant here.) The idea is that if your car is totaled and you have proper coverage, you’ll get enough money to replace your car with something of comparable value.
If you loan or lease your car, though, things are a little more complicated. From the perspective of the company that takes your payments and legally owns your car, they shouldn’t suffer any financial loss because you got into an accident, a tree fell on your car, or whatever else might have happened. They weren’t there and had nothing to do with it. From your perspective, it might seem like gap insurance isn’t there for you, because it’s protecting your lender’s asset. The next section will help explain how gap insurance protects you and your lender at the same time.
How Does Gap Insurance Work?
When your vehicle is a total loss – that is, when the damage is so extensive that it’s not worth repairing – gap insurance comes into play. Gap coverage varies from insurer to insurer. For example, Progressive’s gap insurance policy covers up to 25 percent over your car’s value. If you owe a much bigger percentage on your loan over the car’s value, you should talk to your insurance company to make sure that your gap coverage actually covers the gap in your specific situation.
If your car is totaled and you owe more than it is worth, your insurance settlement will go right to the bank or financial institution that services your loan, since technically, your lender owns your car until you pay it off. On top of that, you’ll also owe your lender the difference between the insurance settlement and the amount left on your loan. In other words, you won’t have a car anymore and you’ll still owe money on it. This is a huge headache and can make it extremely difficult to get a new vehicle and move on with your life. That’s why gap insurance is a good idea whenever you have a loan on a vehicle. You can end up having to cover a gap on your own if you don’t understand how car insurance works and assume you’ll be covered if your car is totaled.
Gap insurance is supplementary, meaning that it's not intended to be a stand-alone policy. It's designed to work together with other types of car insurance – primarily collision and comprehensive insurance.
Who Should Get Gap Insurance?
Gap insurance is a good idea if you owe more on your car than it's worth, which is usually the case with a loan or a lease. Conventional wisdom states that a new car loses a significant percentage of its value the second you drive it off a lot. That’s a huge factor in the “gap” covered by gap insurance.
For example, you can sign loan paperwork stating that you owe $25,000 for your new car, which you'll pay back over a certain timeframe. But as soon as you drive away, that car's value might drop to only $20,000 or so, and that discrepancy between your outstanding loan debt and the car’s actual value is the gap. Why sign a loan for something that’s immediately worth less than you owe? Over time, the amount you owe and the amount the car is worth should start to balance out. There’s just a big discrepancy upfront because the car loses its “brand new” status. Without loans like this, many people wouldn’t be able to buy a car at all. It’s worth noting that the need for gap insurance can apply to a used car as well as a new car. The car’s age isn’t the important part. What matters is how much the car is worth and how much you borrowed to buy it.
So, how long will you need gap insurance on your new car? It depends. A new vehicle typically depreciates 20 to 30 percent over its first year, which averages out to about 17.8 percent by the time it’s six years old. The need for gap insurance goes down as you make more payments on your car and close the gap, but the math can be tricky. The Insurance Information Institute says gap insurance is a good idea with a five-year loan, but other experts are more conservative and suggest that a four-year or longer loan term is the point at which gap insurance makes the most sense.
If you lease your car, chances are good that your leasing company requires you to carry gap insurance until the end of the lease, but even if it is not a requirement, it’s a good idea. Again, if something happens to a leased car, you’re on the hook. Some leases include gap insurance in the terms and price of the lease, so check your paperwork before talking to your insurance company.
Does Everyone Need Gap Insurance?
Not everyone needs gap insurance, and if you don’t fall into any of the categories above (a new car with a loan, a car with a heavy underwater loan, or a lease), you can skip this coverage. People who owe less than their car is worth or own their cars outright can skip gap insurance.
That's because if you own your car outright (that is, you don’t have a loan) or if you have a loan that’s about equal with what the car is worth, your other insurance coverage should be sufficient to cover a total loss. If you own your car and it’s totaled, your insurance will pay you what your car is worth. If you have an outstanding loan in line with your car’s value, the insurance settlement will be enough to satisfy your lender if the car is totaled. Of course, you should make sure your other insurance policies provide a level of coverage that you’re comfortable with, but gap insurance is an additional expense that you can safely skip or cancel.
How to Get Gap Insurance
If you didn’t add gap insurance to your policy when you bought your car, you still might be able to get coverage. If you've decided that gap insurance is a good idea for you, there are a few ways to get it.
Your first and best option for gap coverage is to contact your current car insurance company. Most major insurance companies, such as Progressive, will only add gap insurance to a policy if the policy also includes comprehensive and collision coverage. That's because comprehensive and collision, when applicable, will kick in before the gap coverage comes into play. If you have gap coverage but your collision or comprehensive policies have lapsed, you might find out too late that your gap coverage won’t be honored. Most insurance companies will charge you about $20 a year to add gap insurance to your comprehensive and collision policies. Keep in mind that you’ll still need to pay a deductible for your gap insurance if you make a claim on it.
Have you ever noticed that when you buy a car, the dealership tries to sell you all sorts of additional warranties, policies, and insurance? Some dealerships try to slip these additions in at the last minute, knowing that you're overwhelmed, your mind is swimming with numbers, and you’re exhausted and eager to get out of there. Gap insurance is probably among the products you’re forced to look at as you flip through the sale's documents, and if you have a pushy salesperson, he or she will probably tell you that you’re at risk driving off the lot without it, because if something happens right away, you won’t be covered. (You can get around this by setting up gap coverage with your regular insurance company beforehand, since you should know that the car you are planning to buy will be underwater for at least a couple years.) The coverage the dealership is offering probably won’t break the bank, but you can probably do better through your own insurance company or credit union (which we’ll get to in a minute).
If the dealership's policy looks like a good deal, make sure you pay for it upfront as a one-time fee. A car dealership will likely charge between $400 and $600 for gap insurance and will try to roll that cost into your loan so you’ll pay interest on it. Gap insurance can go for less than $200 from a credit union or insurance company.
If you finance your car through a bank or a credit union instead of through the dealership, they may offer you affordable gap coverage along with your loan paperwork. This coverage is typically a better deal than the dealership’s coverage, though it might not be as good of a deal as your insurance company’s coverage. If you plan to get pre-approved for a loan before you head to the dealership, talk to your insurance company beforehand so you can compare rates and be prepared to make the best decision for you.
Where you get your gap insurance coverage will affect how you pay for it. If you buy insurance through the dealership or a company that specializes in gap insurance, it’s typically a one-time fee, though dealerships may try to get you to roll it into your loan. If you buy gap insurance through your regular insurance company, it will be added to your regular policy and cause a slight increase in your regular premium payment.
Some insurance companies might offer loan or lease payoff coverage instead of gap insurance. While gap coverage pays the balance of your debt, loan or lease payoff coverage pays a set percentage of the car’s value, with the same end goal of letting you walk away from a total loss. If your insurance company doesn’t offer gap coverage but offers loan or lease payoff coverage instead, this acceptable alternative will help you if your underwater car is totaled.
If you’re trying to figure out whether you need gap insurance, it’s probably a sign that this type of coverage is a good idea. If you have a loan or a lease on your car, and your car was totaled tomorrow, could you afford to pay your lender out of pocket to make up the difference between your car’s value and your loan? What you need to remember, and what people often forget, is that if you owe money on a totaled car, your insurance will pay the people you owe, not you. If you are in this situation, like lots of others, gap insurance is a good choice.