Most people who buy a car do so with a car loan. And if you're borrowing money to pay for your vehicle, then there's a chance you could end up owing more than it's worth at some point. This could become a big problem if your car is totaled or if it's stolen and you don't get it back.
The issue: what your auto insurance will cover will only be the market value for your car — but you'd still owe the remaining loan balance, even if it’s higher than the car’s worth.
Fortunately, there's a way to avoid major financial loss in this situation: Buying guaranteed asset protection insurance, also known as GAP insurance. GAP insurance is appropriately named as it covers the gap between the value of your car when it’s lost and the amount you still owe your lender.
If you're taking out a loan to buy a vehicle, you need to know how GAP insurance works and make an informed choice about whether it’s a type of insurance coverage you need. This guide will help you make that decision.
What is GAP insurance?
First things first — what is GAP insurance on a car? Quite simply, it is an insurance policy that covers the gap between what your auto insurer pays you in the event of theft or total loss of your vehicle and what you owe your auto loan lender. This gap occurs when you’re upside down on your loan, which means you owe more on the car than it’s technically worth.
Say, for example, you buy a car and pay the Kelley Blue Book value of $20,000. You put $1,000 down and take out an auto loan for $19,000. You drive your car for a while and the market value goes down to $14,000. But because you took out a long-term installment loan and didn't make much of a down payment so you still owe around $17,000.
If you get into an accident and the car ends up getting totaled, your auto insurer will usually pay out the actual cash value of your car minus any car insurance deductibles you owe. In other words, if you had a $500 deductible, you'd get a check from your auto insurer for $13,500. But you'd still owe your lender $17,000.
In this situation, you'd end up having to pay $3,500 to your lender for a vehicle you no longer have. That's not affordable for most people. But GAP insurance could cover this, and ensure you have the money to pay off your loan when something has gone wrong with your car.
When is GAP insurance worth it?
GAP coverage is usually worth paying for if it's likely there will be a big difference between what you owe on a car and what your vehicle is actually worth. This is more likely to happen if:
- You make a low down payment. A big down payment helps ensure you don't end up owing more than a car is worth, as you reduce the amount you borrow. If you make a small down payment, you won't have this cushion. Say you made no down payment on a brand new $25,000 vehicle and crashed the car a month later. New cars depreciate quickly, typically losing more than 10% of their value during the first month after purchase. In this scenario, you could end up with a $25,000 loan you haven't made a single payment on and an insurance check for just $22,500.
- You have a high interest rate. The higher the interest rate on your car loan, the more time it takes you to pay down the principal, and the more likely it is you'll end up owing more than your vehicle is worth. If you borrowed $20,000 for a car at a 15% rate over five years, at the end of your first year, you'd still owe $17,029. But if the car went down in value by 20%, which is normal for a new vehicle in its first year of ownership, your insurer would compensate you for about $16,000. You'd have to come up with more than $1,000 to pay off your loan if the car was stolen or totaled.
- Your car loan repayment term is longer than five years. A long loan term means you don't make much progress on paying off the principal since your monthly loan payments are small. This makes it very likely you could end up owing more than your car is worth. If you borrowed $20,000 at 7% over 84 months, your loan would be paid down to $17,705 after the first year. But, as mentioned above, your vehicle would probably only be worth around $16,000. That leaves you with a nearly $1,800 gap.
- Your car will depreciate quickly. Sometimes vehicles don't hold their value well. This is likely to happen if the vehicle has high mileage when you buy it, or if you purchase a make or model that isn't in much demand. If you expect your car to decline in value quickly, there's a big chance you could owe more than it's worth and have to come up with thousands of dollars if you total it or it's stolen.
When you probably don't need GAP insurance
Although there are plenty of times when buying GAP insurance is worth it, it makes sense only if there's a good chance you will end up upside down on your vehicle loan. After all, that's the only scenario in which GAP insurance would pay out any money or provide any protection.
As a result, if you make a high down payment on your car, take a short-term auto loan at a low rate, and/or buy a vehicle that tends to hold its value, there would be little reason to buy GAP insurance. If you put down a $7,000 down payment on a $20,000 vehicle and you steadily pay principal over time, it's unlikely your car would depreciate so much that you don't get enough money back from you car insurance policy to compensate you completely on the vehicle’s loss. In this case, GAP insurance would be a type of insurance you can skip.
How to buy GAP insurance
A GAP insurance policy can be purchased directly from a car dealer. You can also often purchase it from your auto insurer as an add-on to your policy. So you might get your collision insurance, comprehensive insurance, and GAP coverage all from the same insurance provider. There are also specialized GAP insurance providers that only offer this product.
Be aware that the price for a GAP policy at a car dealership is often higher than the cost of buying coverage from an auto insurance company or from a stand-alone provider. And some dealers ask for a large initial payment on your GAP policy, whereas your auto insurer will usually allow you to add the GAP insurance cost onto your monthly car insurance bill.
You should always shop around before choosing a policy provider. Get quotes from the dealer, from your existing insurer as well as other car insurance companies, and from a dedicated GAP insurance company. Choose a policy from a provider you trust that offers the most affordable price.
A note on GAP insurance and leased cars
GAP insurance doesn't just help you pay off a car loan. It could also help you if you lease a vehicle.
Leased cars also depreciate in value just as purchased cars do, and you commit to making payments on them for the duration of the lease agreement and returning the car (or buying it) at the end of your lease term. If you total a leased car, your auto insurance policy will typically pay the actual value of it to the leasing company. But if your car is worth less than the lease balance, you'll have to pay the difference. GAP insurance would cover that.
Lease companies often require mandatory GAP insurance coverage as part of your leasing agreement, so you may not need or be able to shop for separate coverage. Just make sure you know whether GAP insurance is included in your lease as you likely don't want to go without it if there's a risk you could end up with a vehicle that's worth less than you owe on it.
When can you get a refund on your GAP insurance?
Although GAP insurance is often worth the money to protect you from substantial losses, you don't want to pay more for your auto coverage than needed. Fortunately, if it turns out the GAP protection isn't necessary, many insurers will offer you a refund. This could happen if you sell the vehicle or pay off your loan early.
In these situations, you wouldn't need to be protected from owing more than the car’s value because your original car loan would be paid off. A premium refund would typically be possible at this point depending on your GAP insurer's specific policies. The insurance provider will often simply require proof of the vehicle’s sale or the loan payoff, and then you’ll be issued a check for the unused portion of the GAP insurance policy.
Although GAP insurance isn't always needed, it is an important form of protection when you borrow or lease a vehicle and run the risk of owing a lender more than the market value of the car. If there's a chance you could end up in a situation in which your auto insurer compensates you less than you owe on your vehicle, make sure you get this protection.
If you need GAP insurance, factor in that cost when shopping for car insurance. And if you don't need it any more because you've paid extra on your loan or paid off the vehicle completely, then remember to drop the coverage to save a little on your auto insurance bill.