Is Gap Insurance Worth It?

Total Loss Accident
••• Getty Images/Steve Cole

Buying a new car can be tricky in so many ways. Hopefully, once you seal the deal, you’ve thoroughly done your research on the best make and model for you, you know how much you should be paying for it and found a good deal, you’ve learned and overcome the tricks car salesmen use to separate you from your cold-hard cash, and you’ve gotten financing for your vehicle with a great interest rate.

But another one of those tricky things you will have to deal with is insurance. We all think we understand what auto insurance is all about. If you get into an accident and your car is damaged, you get it fixed, and the insurance pays for it. If your car is totaled or stolen, you're paid for the car's value, and you get another. There are a few wrinkles, like deductibles, but otherwise, it's pretty simple. Right?

Not so fast. There are lots of other "wrinkles" that are not so simple and, if they show up, can cause you a big headache. Gap insurance could help, but is it worth it?

What is Gap Insurance?

It is, of course, impossible to know if purchasing gap insurance is worth it if you don't know what it is, so here's a quick explanation. We've all heard the expression, "a new car loses half of its value the moment you drive it off of the lot." Now, that's not quite true, but the value does drop substantially within a very short time after purchase, and every brand-new vehicle loses a lot of value in the first year. No matter how old your car is when you buy it, I can guarantee that unless it’s a classic car or you’ve poured your heart (and repair money) into it, it’s going to be worth less than you paid for it in a few years. That's depreciation for you.

Suppose you take out an auto loan, buy a new car and drive it off of the lot. It quickly depreciates enough that its resale value is now less than what you owe on it by several thousand dollars. One month after the purchase, another driver hits your new car and totals it. Insurance is going to pay you the current actual cash value (ACV) of the vehicle which, as we said, is several thousand dollars less than what you owe on the loan. How are you going to make up the difference? That's where gap insurance comes in. Gap insurance pays the policyholder that difference between the ACV and amount owed on the loan.

Why Doesn't Everyone Have Gap Insurance?

Not everyone whose car is stolen or totaled needs gap insurance. It can only benefit those owners who finance the purchase of their new car and then only for that period when their car is worth less than what they owe on the loan. This is what is known as being "upside-down" on a loan. That period can be quite short or surprisingly long depending on one or more of the following factors:

  • Make, and model of car purchased: All new cars depreciate significantly in the first few months after purchase, but some depreciate more quickly than others.
  • Long-term loan: When you take out an auto loan of longer than 36 months, your monthly loan payment will be lower, but you'll pay much more in the long run, and there will be a more extended period when your car's ACV will be less than what you owe on the loan.
  • Putting very little or no money down, and borrowing more than the purchase price: The more debt you take on up front, the longer that "gap" is going to be there.

What is the Cost of Gap Insurance and is It Worth It?

One thing that most people do not want to hear about is voluntarily adding to the cost of purchasing a new car by suggesting that an optional form of insurance would be a good thing to buy. Fortunately, gap insurance is pretty cheap. A typical gap insurance premium is calculated based on the collision and comprehensive coverage premiums in a policy and runs about five to six percent of that cost. So, let's take a total annual premium cost of $1,500, for example. The comprehensive and collision part of that total is approximately 30% to 40% or $450 to $600. Five to six percent of that means a total of between $22.50 and $36 additional cost on your premium for gap insurance, and that is for a full year.

Remember two more things. First, as your vehicle depreciates, the cost of your comprehensive and collision coverage will decrease, and so will the cost of your gap coverage. And second, once you have reached that point when you no longer owe more on your vehicle than its current ACV, you won't need gap coverage anymore and you can cancel it.

Before you purchase gap insurance, it is worth doing the math to see how much gap insurance will benefit you. If you’re only a little bit upside down on your loan, it might make more sense to simply save up in a savings account for the possibility that you’ll end up needing “gap insurance.” If you go this route, worst case scenario, you pay with money you’d already budgeted for, and best case scenario, nothing happens to your vehicle and you get to keep the money.

Why is Gap Insurance so Cheap?

Gap coverage is so inexpensive because very few claims are ever made against a gap policy, and that lowers the premium costs for you and everyone else.

Gap insurance, unlike regular insurance, only covers a very specific amount of money (the amount of your loan minus the amount of money your car is worth) for a very specific amount of time (until that equation is zero or negative).

So, is gap insurance worth it? That's for you to decide. But if you are purchasing a new car and don't have a lot of extra cash sitting around while your loan is upside down, you should give gap insurance some serious thought.