Most cars depreciate in value, which can leave car loans costing more than the value of the car. In the world of loans, that’s called being upside down — meaning you owe more than what the car is worth.
That’s not a good thing, and that’s why there’s GAP insurance, or guaranteed asset protection insurance. It covers the difference between the loan amount and the value of your vehicle after depreciation if you get in an accident or your car is totaled.
The average new car loses 11 percent of its value the moment it’s driven off the dealer’s lot, according to Edmunds.com. During the first five years the car depreciates by 15-25 percent each year.
If your car is totaled, your insurance company is only going to pay you the current value of the car before it was totaled, not the original purchase price. If you owe the bank more than the value of the car, you still have to pay the loan.
GAP insurance could help fill that hole, covering the difference between what you owe and what your vehicle is worth. For example, if you owe $20,000 on your car loan and the vehicle only has a Kelley Blue Book value of $15,000, your regular auto insurance will only cover up to the $15,00 and GAP insurance would pay the remaining $5,000. It can also be needed when rolling over negative equity from a prior auto loan to a new auto loan, or purchasing a car for more than MSRP. Without GAP insurance, a borrower’s debt-to-income ratio could be affected by the remaining balance on the totaled vehicle being shown on their credit report until the debt is paid off in full.
Costs of GAP insurance
A car dealership is usually the first place where car buyers learn about GAP insurance, especially if they’re financing their purchase through the dealer. But they don’t have to buy it from the dealer, and they don’t have to buy it immediately. Dealers often charge more than your insurance company or credit union will for the same GAP insurance policy.
All policies should offer the same coverage. The major difference will be in price. A dealership will usually sell GAP insurance for $700 to $1,000 for the life of the loan, versus $200 to $400 at a credit union.
To collect on a GAP policy, you’ll need to show the GAP insurer documentation from an auto insurer for your totaled car that includes the amount they’re paying. That payment will go directly to the loan company. You’ll still need to make monthly loan payments after the accident until the loan is fully paid off.
The GAP insurer will want documentation from the lien holder that the insurance proceeds are less than the amount owed. It will then pay the lien holder the balance.
Other ways to cover yourself
If you buy GAP insurance from a car dealer, the cost can be rolled into the loan and you won’t see much of an increase in the monthly payment. Or you could pay for a year of GAP insurance at one time, which may be difficult to do, or your insurer may allow you to make monthly payments if you buy it through them. GAP insurance often isn’t needed after three years once enough equity is accumulated. That can be a good time to check on the value of your car and see if you no longer need GAP insurance.
Instead of buying GAP insurance, one option is to take that savings and put it aside in case your car is totaled and you owe more than the car is worth. The average age of a car on the road today is 11.5 years, Young says, so many owners probably don’t need GAP insurance. But if they do, they should consider how they’d pay for that gap if their car is totaled.
Another option, if you can afford it, is to put a large enough down payment down when buying a car so that the loan is reduced to the Blue Book value or below, and you won’t need GAP insurance.
When to get GAP insurance
Most people aren’t disciplined enough to put money aside for such a payment, and GAP insurance would work for them when it’s needed the most — in the three years after a new car is bought. Another time when it makes sense to buy Gap insurance is if you have bad credit and have a high interest rate on your car loan. If you’re financing a car with a minimal down payment or you have little to no equity after financing the car, GAP insurance could save you thousands of dollars. Some lease agreements also require GAP insurance.
The good news is that if you do need GAP insurance, you’ll probably only need it for three years or so before you build up enough equity. It’s just a matter of deciding if you want to take the risk of not having it during that time, and hoping you don’t get into a major accident.