What is Gap Insurance and Why Would You Need It?

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If you're upside down on your car loan, you may be in for a surprise if you total your car.

If you’re upside down on your car loan, you may be in for a surprise if you total your car. (image by nevblog.com)

One set of questions that we’ve had asked time and time again related to gap insurance (also known and referred to as loan/lease payoff). Exactly what is gap insurance? What does it do? And why would a consumer want to have it? We’ll get to each of these questions, but first, we’d like to address some myths concerning gap insurance, and what it isn’t and won’t do:

  • Gap insurance will not pay off your car if it is repossessed.
  • Gap insurance will not pay for repairs to your car from mechanical failure.
  • Gap insurance won’t make your monthly payments if you lose your job, become disabled, die or suffer other financial hardships.
  • Gap insurance won’t act as the downpayment on a new car if your automobile is totaled.
  • Gap insurance won’t pay for any extras you may have financed with your car, such as an extended warranty or the amount of your previous upside down loan rolled into your current automobile.

Gap insurance is an optional auto insurance coverage that will ensure a financed car is paid off in the case of a total loss. It pays the “gap” amount between what you owe on a car, and the actual cash value of the automobile. So why would someone need this type of insurance? Let’s consider some example of where gap insurance is a good idea.

  • You’ve financed a car – new or used – without providing at least a 20 percent down payment. Because automobiles depreciate quickly, losing at least 10 percent of their value as soon as they’re driven off the lot and 20 percent or more in the first year of ownership, you may be “upside down” on your loan if your car is totalled, meaning you’ll owe more than your insurance company will pay.
  • You’ve traded in a car you currently have financed and owe more than it is worth. The amount above the worth of your trade in is rolled into your new car loan. Even if you put a down payment of 20 percent in on the new car, you’re still upside down on the new loan, due to the rollover.
  • You’re leasing a car. Because most auto insurance policies only pay actual cash value on any loss, you’d still be out the difference between the residual value of leased car, and the amount of payoff.
  • In order to have a lower monthly payment on a purchase, you’ve selected a loan term of more than 36 to 48 months. Because so little principal is paid in the first few years of a loan – you’re generally just covering interest – you’ll be upside down, even with a substantial down payment.

Gap coverage is generally only available if you have collision and comprehensive coverage, and if the car is financed or leased.  Most leasing companies offer gap coverage, and will roll the coverage into the lease payment. Some will even require  Most car dealers will also offer gap coverage on new and used automobiles, and they’ll simply add the amount of gap coverage into the loan.

If you find gap insurance is a good idea and a product you need, we’d say skip the dealer-offered coverage if you have to finance it along with the car in the loan – instead, before you buy, shop around. Your current insurer may offer gap insurance, which could potentially open up extra discounts, since you’d be bundling multiple policies – auto and gap – and if they do not, plenty of options exist. There are many companies that only provide gap insurance, and most traditional insurers offer it as well.

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