When researching auto insurance, you'll find that you have several policy options, some of which are mandatory and others optional. Along with traditional liability, collision and comprehensive policies that cover damages minus a deductible, you can purchase guaranteed asset protection (gap) coverage that helps if you owe money on a totaled vehicle but don't get a large enough insurance payout to cover the whole balance. This option has some benefits and limitations, so looking at your vehicle's value and financial situation is crucial. Use this guide on gap coverage to learn when and why to consider it.
Car Loans and Insurance Requirements
Taking out an auto loan is a common step when you buy a new car since it can allow you to pay a small down payment and pay the rest of the amount over several years. You'll pay a car payment every month composed partly of interest due and partly of loan principal until you've reached a zero balance. The amount owed doesn't change simply if your vehicle's value goes down. To avoid issues like credit damage and repossession and to have a clear title, you'll need to pay off the loan according to the lender's terms and avoid skipped or late payments.
Read More: The Best Auto Loan Interest Rates for 2020
Whether you finance your car or not, there's a good chance your state will have rules about mandatory car insurance coverage that include purchasing a policy with certain coverage limits or else show proof of cash reserves that meet those limits. At a minimum, this will include liability insurance or enough personal funds to meet state requirements. If you can't meet these requirements, you can run into problems registering your vehicle in the first place. You can also face financial and legal headaches if you're at fault in a car accident or get caught driving without insurance.
The Insurance Information Institute (III) says that the types of car insurance coverage you have will affect how well you're protected and in which situations you'll get reimbursed. For example, if you only carry liability coverage for your car and wreck into another vehicle, you'll be on the hook for costs related to damage to your car, but your insurance carrier will pay for the damage done to the vehicle you hit. If you've financed a new car, you're more likely to carry both collision and comprehensive coverage that will reimburse you for damage to your own vehicle even if you cause the accident.
How Car Insurance Payout Works
When it comes to car insurance claims, usually the at-fault driver's car insurance company will pay for damages to the vehicle or other property they damaged in the accident. For example, if you're at fault for a fender bender, then your insurance covers the damage to the other vehicle. On the other hand, the other person's insurance company would pay if their vehicle had instead hit your car. However, how the car insurance company handles the reimbursement will depend on the damaged car's value and the extent of the damage.
The insurer will look up the value of your car and compare it to the estimated repair cost. The value the insurer calculates will take into account how much depreciation the car has accrued over the time you've owned it. Depreciation lowers your car's value over time until there's little to no value left, and it happens due to the wear and tear your car will sustain as you use it. For example, you might have paid $25,000 for a car that incurred $5,000 in depreciation the first year, leaving you with a vehicle value of $20,000.
If the repair cost is a reasonable amount less than the car's value calculated, then the insurance company usually just pays for the work that needs done, although you'll be responsible for any deductible that applies. However, the car insurance company will consider a vehicle to be "totaled" when it needs repairs either nearing or beyond the vehicle's value. Therefore, you can't expect to get reimbursed for more than your car's actually worth, and this can lead to a tricky financial situation.
Read More: How Much Is My Car Worth?
How Loans and Insurance Relate
In the case of a totaled car that still has a loan on it, you'll need to have the insurance funds put toward the balance of the loan. But depending on the loan balance and value of your car, there can be a gap remaining where you still owe money on the car and will need to pay off that amount using your own money. This gap can happen due to the normal depreciation vehicles incur, other things you had added to the loan and factors that have made it challenging to pay down your car loan's principal fast enough.
Whenever your car loan exceeds your car's value, then you've got an upside-down loan. This happens since owing more than your vehicle's value leads to having negative equity. It's a problem since it can leave you on the hook for a substantial amount of money if you end up totaling your car and owing the lender some extra money. Even having full coverage won't help you avoid this issue.
For example, consider that you have a $10,000 auto loan on a car currently worth $6,000. Your car gets totaled in an accident, so the at-fault party's insurer pays you $6,000 that you then apply toward the existing loan. Now you're left without a car and with $4,000 to pay on the loan.
Understanding Gap Insurance
If you want to avoid owing your lender after your car's considered a total loss, then you can look into purchasing gap insurance to offer you some extra financial protection. While your regular car insurance will pay up to the car's depreciated value, the gap insurance covers the difference between the payout and your auto loan. However, there are some important exclusions to know.
The gap insurance won't pay for the part of your auto loan that might have been used to buy extras like extended warranties or protection plans. It won't pay for any portion related to a rolled-over auto loan for a past vehicle either. You may also still need to pay your car insurance deductible unless you choose a gap policy that handles that for you. Further, insurers might set a limit on gap coverage based on the car's actual cash value.
Looking back at the last example, consider that you have gap insurance when you end up with the $4,000 remaining loan balance after the regular insurance payout. That whole amount was used for the car itself and no extras, so it all qualifies under the gap coverage. Therefore, your gap insurance would kick in and save you from needing to pay off the remaining loan yourself.
Gap Insurance Pros and Cons
The main benefit of gap insurance involves the safety net it provides when your car has depreciated significantly and your car loan balance hasn't caught up with the changes. You can have more peace of mind buying a new car with a lower down payment if you opt for this coverage, and the depreciation becomes less of a problem in the event your car gets totaled or stolen. While you'll still need to pay for the price of the gap insurance, it can be much less of a hassle than having to pay off a large loan yourself.
Gap insurance's main downsides include the exclusions to coverage plus the fact it may not actually benefit you in certain situations. Along with not covering extras like extended warranties and carried-over loan balances, gap insurance won't help you purchase a new vehicle after yours is a total loss, and it won't pay off your car loan for non-accident-related events like the death or disability of a borrower. If you don't have a car with negative equity, then the gap insurance will just be an additional cost to you and won't provide a benefit since your regular insurance should cover what you owe.
Read More: The Pros & Cons of Gap Insurance on New Cars
Deciding Whether You Need Gap Insurance
Before you start looking for gap insurance coverage, make sure that your situation warrants and requires this product to avoid spending money unnecessarily. For example, the III mentions that you'll probably have to get this coverage anyway if your lender or lessor requires it.
However, it can make sense in other situations to opt for the coverage when you don't put much money down, choose a car with fast depreciation, select a long loan term or otherwise face a situation where you'll likely find yourself with negative vehicle equity. Otherwise, you'd be left needing to cover the balance if your car gets totaled.
If you're looking into gap insurance after you've owned the car for a while, doing some math can help you decide whether this option makes sense financially. First, use an online resource like Kelly Blue Book to look up the current value of the car and then get the current auto loan balance from your lender. Subtract the loan balance from the car's value to get a negative or positive number that will represent your equity. If you end up with negative equity that you couldn't make up for with your cash if necessary, then gap insurance can be a good option.
Getting a Gap Insurance Policy
When you go to buy a car at a dealership, you can usually conveniently purchase a gap insurance policy and have the cost rolled into your loan. You'll complete the paperwork for this policy alongside others for the car purchase and financing. You might also find out at this time that your lender requires gap insurance coverage, but you should verify that before proceeding. Further, you don't need to feel pressured to buy the gap coverage at the dealer, and you'll often find the price considerably higher than through insurance companies directly.
You can also contact your existing car insurance company and tell them you need gap insurance. You'll get a quote for how this will affect your monthly premiums, and then you can fill out any additional forms and make a payment to get the coverage started. If you find the price of your car insurance policy plus gap insurance expensive, you could start shopping around to find an insurer that better fits your budget.
Keep in mind that you only need to keep your gap coverage until you've reached the point where you don't have an upside-down auto loan. This can take a few years depending on factors like your loan term and your car's rate of depreciation. You can reach out to the company providing gap coverage to cancel when you're able, and if you paid a large sum upfront, you might get a prorated refund.
Avoiding Needing Gap Insurance
The easiest way to avoid needing gap insurance is to not get in a situation where you have an upside-down auto loan. This could mean making a 20 percent down payment on your car, choosing a shorter term, accelerating your payments or choosing a vehicle that retains its value better.
You could also look into a loan/lease payoff policy that your insurer might offer since this can help pay off a specific amount of your car's value and help you financially if you face a total loss. The loan/lease payoff option usually applies to used vehicles rather than new ones. Be warned, though, that some car insurance companies use this same term to mean traditional gap coverage, so you'll want to verify this.
Read More: How to Stop Gap Insurance Coverage
- Insurance Information Institute: What Is Gap Insurance?
- Consumer Financial Protection Bureau: What Is Guaranteed Auto Protection (Gap) Insurance?
- Insurance Information Institute: What Is Auto Insurance?
- Insurance Information Institute: Is It Legal To Drive Without Insurance?
- Insurance Information Institute: How To File an Auto Insurance Claim
- Allstate: When Is A Car Considered Totaled?
- Navy Federal Credit Union: Car Depreciation Calculator
- Federal Trade Commission: Auto Trade-ins and Negative Equity
- IRMI: Probing the Gaps in GAP Insurance
- Consumer Financial Protection Bureau: What Should I Know About the Differences Between Leasing and Buying a Vehicle?
- Bankrate: Gap Insurance
- NerdWallet: Gap Insurance: What It Is and Who Needs It
- Consumer Financial Protection Bureua: Servicemembers, Arm Yourself With Basic Car Buying Skills—How To Trade in Your Car
- Kelly Blue Book: Home
- Consumer Finance Protection Bureau. "What Is Guaranteed Auto Protection (GAP) Insurance?" Accessed August 21, 2020.
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.