What Is Gap Insurance and Do I Need It?

Every new and certified pre-owned vehicle will depreciate as soon as you drive it off the lot. Different models are better at holding their value than others, but every owner can expect her car to be worth less than what she paid for it as soon as she leaves the dealership.

This poses an interesting dilemma for buyers who finance their vehicle purchase. In the case of an accident where the vehicle is considered a total loss (totaled), it is possible that a buyer who financed all or most of the vehicle purchase could owe the financing institution several thousand dollars more than the deductable.

How in the world does this happen? Well it turns out that in the case of a total loss insurance companies pay out what the vehicle is actually worth, not what you paid for it and not what you owe on the loan. So for example, you buy a car for $21,000. You put $1000 down and finance the other $20,000. But as soon as you drive it off the lot the car is only worth $19,000. The next day you get into an accident and the car is considered a total loss.

How much does your insurance company owe you? $19,000

How much do you owe the financing company? $20,000

That $1,000 difference is considered the “gap,” which gap insurance covers if you purchase it.

Do I need it?

You should take into consideration several factors when deciding if gap insurance is right for you. First and foremost, there is no reason to purchase it if you buy your vehicle outright. As a general rule, the more equity you have in your vehicle (meaning the more money you have put into the purchase), the less value gap insurance provides.

As a car buyer, you should also consider how much your vehicle depreciates every year. The better your car holds its value, the less important gap insurance is. Calculating the rate of depreciation for any given car is not an exact science, but you can look at how the same model vehicle of different years has retained its value over time. You can also try calling your insurance company to see if they have a depreciation schedule for the car you are interested in buying.

One last factor you should consider is your own risk tolerance and your financial situation. For many people, having to shell out $2,000 after your car is totaled to fill the “gap” would be financially devastating. If this is the case, maybe it is worth buying the gap insurance to protect yourself for the first year, or until what you owe on the vehicle is equal to or less than what you owe on the loan. For others who don’t mind the risk as much, gap insurance might not be the best purchase.

One thing is for sure, though. Dealerships make a commission off of selling you gap insurance and it is, therefore, almost always more expensive to purchase gap insurance through a dealership than it is directly through your insurance company. But buying gap insurance, just like financing, is generally more convenient through a dealership. So there is a tradeoff between convenience and cost, but that’s just life.

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