It could be the second biggest purchase you ever make, so not everything about buying a new car is going to be straightforward – including your insurance.
But is it something you actually need? Not necessarily – and here’s why.
What is gap insurance?
Gap insurance pays the difference between the balance of a lease or loan on a vehicle and what your insurance company otherwise pays if the car is totaled or stolen.
Unlike other major life purchases like buying a home, a new car is destined to decline in value. While a house prices can go up and down, vehicles lose a significant chunk of their value the moment you drive them off the lot.
This matters because any other types of car insurance you might have such as collision or comprehensive coverage will settle the claim based on the actual cash value (ACV) of the car.
Looking at the graph above you can see that the drop in the vehicle’s value means any insurance settlement based on ACV will be less than what the vehicle was bought for.
How does gap insurance work?
If your car is totaled and you still have most of the loan outstanding, the amount you owe could be higher than the value of the insurance payout.
Consider this situation: You’ve bought a new car for $50,000. As soon as you drive it off the lot, it will have depreciated to something like $35,000. Had you borrowed the $50,000 to buy the car, there would now be a $15,000 gap between the car’s value and the amount outstanding on your loan.
If the car gets totaled, meaning you need a replacement, your insurance would only cover the value of the vehicle after depreciation (in this example the $35,000).
Your insurer would pay the financing company this actual cash value figure but you would owe whatever remains of the loan.
Gap insurance is to protect you being on the hook for that type of shortfall.
If you do have gap coverage, the insurance company pays the financing company the ACV amount as well as whatever is outstanding on the loan.
Do I need gap insurance?
The situation where gap insurance could apply is mostly for people that make smaller initial down payments (e.g. less than 20 percent), or financed for a longer period of time (e.g. 60 months or more).
If you aren’t in a situation where you will owe more on a vehicle loan than what the car is worth, you don’t need gap insurance.
Even if this applies to you, shopping around before you buy is essential. Gap insurance might not even be the best solution.
A policy that includes new car replacement might actually be a better bet.
New car replacement
Gap insurance isn’t the only way to protect yourself when paying off a vehicle loan.
Instead of purchasing gap insurance, you can upgrade your car insurance policy to cover new car replacement.
If the vehicle is under one year old and under 15,000 miles, this would pay out the full value of replacing the car new.
Unlike gap insurance where you are just insured for the gap in value, and would still be required to arrange a new vehicle loan and downpayment, new vehicle replacement would mean you just continue making payments as it nothing had happened.
For new cars, this could be a lower cost way of getting coverage when paying off an auto loan.
In some cases, adding new car replacement to your policy might only add as little as $5 per month to your premiums.
So before you buy gap insurance, shop around a little. There are other options out there that could make more sense.