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Most people who buy a car do so with a car loan. And if you're borrowing money to pay for your vehicle, then there's a chance you could end up owing more than it's worth at some point if you're in an accident or your car gets stolen.The issue is that your auto insurance will only cover the market value for your car. You'd still owe the remaining loan balance on your loan, even if it's higher than the car's worth.
Fortunately, there's a way to avoid major financial loss in this situation: Buying guaranteed asset protection insurance, also known as GAP insurance. GAP insurance is appropriately named as it covers the gap between the value of your car when it's lost and the amount you still owe your lender.
If you're taking out a loan to buy a vehicle, you need to know how GAP insurance works and make an informed choice about whether it's a type of insurance coverage you need.Â
What is GAP insurance?
First things first — what is GAP insurance on a car? Quite simply, it is an insurance policy that covers the gap between what your auto insurer pays you in the event of theft or total loss of your vehicle and what you owe your auto loan lender. This gap occurs when you're upside down on your loan, which means you owe more on the car than it's technically worth.
Say, for example, you buy a car and pay the Kelley Blue Book value of $20,000. You put $1,000 down and take out an auto loan for $19,000. You drive your car for a while and the market value goes down to $14,000. But because you took out a long-term installment loan and didn't make much of a down payment so you still owe around $17,000.
If the car is totaled in a covered accident, your auto insurer would generally pay its $14,000 actual cash value, minus your deductible. With a $500 deductible, that would leave a $13,500 insurance payment against a $17,000 loan balance.
You would still owe $3,500. Of that amount, $3,000 is the difference between the car's value and your loan balance; the other $500 is your deductible. GAP coverage could pay some or all of the shortfall, but check your plan's terms to see whether it covers the deductible.
When is GAP insurance worth it?
GAP coverage is usually worth paying for if it's likely there will be a big difference between what you owe on a car and what your vehicle is actually worth. This is more likely to happen if:
- You make a low down payment. A larger down payment reduces the amount you borrow and can lower your chances of owing more than the car is worth. For example, if you financed the full $25,000 price of a new car and it was worth $22,500 when it was totaled, you could face a $2,500 difference between its value and your loan balance, assuming you had not yet made a payment. That example is hypothetical; the amount a particular car loses in value will vary.
- You have a high interest rate. A higher rate means more of each early payment goes toward interest instead of reducing what you owe. If you borrowed $20,000 at 15% APR for five years, you would owe about $17,096 after 12 regular monthly payments. If the car were worth $16,000 at that point, the difference would be about $1,096, before any insurance deductible. The $16,000 value is an example, not a prediction of how much your car will depreciate.
- Your car loan repayment term is longer than five years. A long loan term means you don't make much progress on paying off the principal since your monthly loan payments are small. This makes it very likely you could end up owing more than your car is worth. If you borrowed $20,000 at 7% over 84 months, your loan would be paid down to $17,705 after the first year. But, as mentioned above, your vehicle would probably only be worth around $16,000. That leaves you with a nearly $1,800 gap.
- Your car will depreciate quickly. Sometimes vehicles don't hold their value well. This is likely to happen if the vehicle has high mileage when you buy it, or if you purchase a make or model that isn't in much demand. If you expect your car to decline in value quickly, there's a big chance you could owe more than it's worth and have to come up with thousands of dollars if you total it or it's stolen.
When you probably don't need GAP insurance
GAP coverage may offer little value if you're unlikely to owe more than your car is worth. It generally applies when a covered theft or total loss leaves you with an eligible loan balance greater than the insurance payment. Coverage limits and exclusions vary by plan.
As a result, if you make a high down payment on your car, take a short-term auto loan at a low rate, and/or buy a vehicle that tends to hold its value, there would be little reason to buy GAP insurance. If you put down a $7,000 down payment on a $20,000 vehicle and you steadily pay principal over time, it's unlikely your car would depreciate so much that you don't get enough money back from you car insurance policy to compensate you completely on the vehicle's loss. In this case, GAP insurance would be a type of insurance you can skip.
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How to get GAP insurance
A GAP insurance policy can be purchased directly from a car dealer. You can also often purchase it from your auto insurer as an add-on to your policy. So you might get your collision insurance, comprehensive insurance, and GAP coverage all from the same insurance provider. There are also specialized GAP insurance providers that only offer this product.
GAP coverage sold at a dealership may cost more than an option offered by an insurer or lender, so compare prices and terms before buying. If you add a dealer's GAP product to your car loan, you'll also pay interest on that cost. An insurer's option may instead be billed with your auto policy.
You should always shop around before choosing a policy provider. Get quotes from the dealer, from your existing insurer as well as other car insurance companies, and from a dedicated GAP insurance company. Choose a policy from a provider you trust that offers the most affordable price.
GAP insurance for leased cars
GAP insurance doesn't just help you pay off a car loan. It could also help you if you lease a vehicle.
Leased cars also depreciate in value just as purchased cars do, and you commit to making payments on them for the duration of the lease agreement and returning the car (or buying it) at the end of your lease term. If you total a leased car, your auto insurance policy will typically pay the actual value of it to the leasing company. But if your car is worth less than the lease balance, you'll have to pay the difference. GAP insurance would cover that.
Lease companies often require mandatory GAP insurance coverage as part of your leasing agreement, so you may not need or be able to shop for separate coverage. Just make sure you know whether GAP insurance is included in your lease as you likely don't want to go without it if there's a risk you could end up with a vehicle that's worth less than you owe on it.
How to get a GAP insurance refund
If you sell your car, refinance, or pay off your auto loan early, you may be entitled to a refund of unused GAP charges. The amount and process depend on your agreement and applicable rules, so don't assume the refund will happen automatically.
Check your GAP paperwork and contact your lender, the GAP provider, or the dealer that sold you the coverage. Ask what documentation they need, how any refund is calculated, and whether it will be paid to you or credited toward a balance.
Bottom line
Although GAP insurance isn't always needed, it is an important form of protection when you borrow or lease a vehicle and run the risk of owing a lender more than the market value of the car. If there's a chance you could end up in a situation in which your auto insurer compensates you less than you owe on your vehicle, make sure you get this protection.
If you need GAP insurance, factor in that cost when shopping for the best car insurance for you. And if you don't need it any more because you've paid extra on your loan or paid off the vehicle completely, then remember to drop the coverage to save a little on your auto insurance bill.
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