Buying a new car can be tricky in so many ways. But another one of those tricky things you will have to deal with is insurance. You may think you 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 get paid for the car's value, and you get another one. Right?
Actually, car insurance isn't that simple. There are some issues that can cause you a big headache, such as gap insurance. While it can be helpful, you should make sure it's worth it before you buy.
What Is Gap Insurance?
You may know that a brand-new car's value begins depreciating as soon as it's driven off the lot. Now, suppose you take out an auto loan, buy a new car, and drive it home. 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 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 the difference between the ACV and the amount owed on the loan.
When You Need (and Don't Need) Gap Insurance
Not everyone whose car is stolen or totaled needs gap insurance. It only benefits 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. In that case, there's a longer 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 upfront, the longer that "gap" is going to be there.
What Is the Cost of Gap Insurance, and Is It Worth It?
While you may not be excited about the idea of voluntarily purchasing an optional form of insurance, it may be worth it—depending on your situation.
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 it typically costs about 5% or 6% of that cost.
Here's an example of a policy with a total annual premium cost of $1,500. The comprehensive and collision part of that total is approximately 30% to 40%, or $450 to $600. Taking 5% or 6% of that is a total of somewhere around $22.50 and $36 additional cost on your premium for gap insurance. That's the total 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. 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 end up saving for the possibility of gap insurance, the worst-case scenario is you pay with money you’d already budgeted for. In the 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.