Car Loan Gap Insurance Coverage
Gap coverage can help you steer clear of financial risk when you're financing your car.
If you have leased or financed your car, even if you have other types of commonly recommended (or required) car insurance -- like liability, collision, or personal injury protection coverage -- you're at financial risk if you don't have gap insurance coverage. Read on to learn more.
Collision and Liability Pays What Your Car is Worth
The goal of most insurance coverage is to put the insured in as good a position as he or she would have been but for the accident. That means that it pays an amount equal to the then-current value of the insured property -- in this case, your car. This is true whether you are collecting under your own policy (e.g. collision) or by making a claim against someone else (and so collecting under their liability policy.) What you receive is equal to what the car was worth at the time it was destroyed or totaled. (Note: if the car suffered light to moderate damage but is economically repairable, insurance will typically pay the repair cost.)
Unfortunately, if your car was totaled, you will receive less than you paid to buy it, because it’ll be worth less than you paid to buy it. (Learn more about Vehicle Damage and Actual Cash Value.)
Depreciation Steals Value
An old car is not worth as much as a new car, even if the older car is in top-notch condition. That’s because of depreciation, which is the reduction in value of the car over time. Almost all assets depreciate over time -- real estate is one of the very few that (usually, or on average) appreciates, or increases in value.
However, cars depreciate particularly quickly. For example, according to one commonly used “depreciation” calculator, the average car purchased new for $20,000 is only worth $15,000 a year later. That’s right: it lost 25% of its value in a single year!
Leases and Loans are Paid Down More Slowly Than the Car Depreciates, Creating the Dreaded “Gap”
Say that you financed a $20,000 car at 6% for 48 months, with zero-dollars down. The total amount you owe under the loan is $22,545.60. If you car was totaled on the one-year anniversary of your owning it, you’ve paid a total of $5,636.40; however, since you owe the full amount you contracted for or agreed to under the loan, you still owe $16,909.20. The most you’re going to receive for the car is $15,000; the insurer may well propose paying less, such as if you had driven more-than-typical miles, had previously been in a minor fender bender, or had anything which would reduce the value of your car from its optimal depreciated value.
Depending upon what source the insurer uses to calculate your car’s value and what assumptions it bases its calculations on (as well on make and model; some types depreciate faster than others), you might only receive $13,500 to $14,500 for your car.
However, even if you received the full $15,000 for the average one-year-old car, that still leaves you $1,909.20 in the hole—you have to pay almost $2,000 to the lender to make them whole, for the privilege of having had your car destroyed. That $1,909.20 is the “gap” -- the difference between what you’ll collect under insurance and what you have to pay.
The same thing happens with leases. The way most leases are structured, at most points along the lease timeline (especially early on in the lease), the amount you’ll owe to pay off the lease in full is more than your car is then worth.
For more expensive models, the problem will be exacerbated, since the gap between car value and lease/loan amount grows faster.
Gap Insurance Insures the Gap
Gap insurance is exactly what it sounds like. It provides coverage that will pay off that gap between loan and potential insurance proceeds. It protects you from the gap. Gap coverage is available in most states, and car buyers often decide to purchase gap coverage through the lender who is financing the vehicle purchase. But you can usually get it from car insurance companies as an additional coverage option.
It's important to understand what you're getting, and to shop around for the best coverage value for your situation. Whichever coverage option or carrier you choose, make sure that all types of vehicle loss are included in the coverage, including accidents, car theft, and damage from a natural disaster.
Learn more about Different Types of Car Insurance Coverage.