When you first get a new car, you’re probably excited about driving your vehicle and not about the auto loan you took out to finance it. But what would happen if you totaled your car? Would you have enough money to pay off the loan?

In many cases, the answer is yes. Standard auto insurance can pay for covered repairs and even the cost to replace the vehicle if it is badly damaged or stolen. But sometimes the insurance money isn’t enough to pay off the loan. That’s because you can owe more than what your car is worth.

Why Is My Car Worth Less Than What I Owe?

The idea that you can owe more than what your car is worth may be difficult to wrap your head around, but this is a fairly common scenario. Industry expert Edmunds.com reported in April 2020 that a record 44% of car buyers are “underwater” on their loans. This means that all of those cars were worth less than what their owners owed on their car loans—an average of $5,571 less!

Wondering how this happens? It’s easier than you think. Maybe you put little (or no) money down when you bought the vehicle, financing the bulk of your purchase, which added interest to the total cost of the car. Perhaps you even rolled in what you still owe on your previous car into your new loan. Or perhaps you took on an extended-term auto loan (i.e., one lasting 48 months or longer) to lower your monthly payments.

Doing any of these things means that less money goes toward the principal amount you borrowed, so it takes longer for your loan to shrink than it does the value of your car.

What Is Depreciation?

But why is the value of your car shrinking? Even as you’re making payments based on the value of your vehicle at the time you took your loan, your car is getting older and is worth less every day. This is due to depreciation.

Depreciation is the reduction in the value of an asset due to wear and tear. And when that asset is something that you and your family use often, like a car, the wear and tear have a significant impact on its value, particularly if you bought a brand new car. As soon as you drive the car off the lot, its value begins to drop, yet you’re still responsible for the full loan amount plus interest, so the gap between the value of what you own and what you owe begins on Day 1 of car ownership.

What Is Gap Insurance?

If the car is totaled or stolen before you’ve paid off your loan, you might find yourself struggling to afford a replacement vehicle, while dealing with the physical and emotional trauma from the accident or theft. Gap insurance can ease the strain.

Gap insurance pays the difference between what a vehicle is worth when it is stolen or “written-off” (i.e., when the cost to fix the car’s damage is greater than the cost to replace it) and the balance on your auto loan or lease. In other words, it fills the “gap” between the vehicle’s current value and what you still owe on it.

Is There Anything Gap Insurance Doesn’t Cover?

Gap insurance may cover some of the financial burden if you find yourself owing more than your car is worth when it’s damaged or stolen. However, there are some things it does not cover, including:

  • Cost of extended warranties
  • Non-refundable security deposits for leased vehicles
  • Overdue lease or loan payments at the time of loss
  • Lease penalties due to abnormal wear and tear, excessive use, or high mileage
  • Accident, credit life, disability, or health insurance associated with the loan or lease
  • Carry-over balances from previous loans or leases

Do I Need Gap Insurance?

If the amount you owe on your auto loan or lease isn’t greater than the current value of your car, you may not need gap insurance. To estimate this, look up the Kelley Blue Book value of your vehicle, and then compare that against the current balance on your loan or lease. Remember to account for the deductible you would pay in the event of a crash or theft (if any), as well as any of the items mentioned above as possibly not being covered by gap insurance.

Where Do I Buy Gap Insurance?

Gap insurance is available through your car dealer, lender or insurance company. If you buy it from your car dealer or lender, you may have to pay for it up front. If you buy it from your insurance company, they may roll it into your auto insurance payment. If you lease a car, it may be included in your lease agreement, so you should check for this before your sign the paperwork.

Gap insurance is not available in all states.

What Is New Car Replacement Insurance?

If you’re buying a new vehicle, in addition to gap insurance, consider new car replacement coverage. Some insurers include this coverage in their auto policy, whereas others offer it as an add-on. With new car replacement coverage, if you total your new car before a set number of miles or a set period of time, your insurance company will replace the car. The replacement will be a new vehicle of the same make and model and will have the same equipment as your original vehicle.

Buying or leasing a car is a significant decision. It’s important to understand the financial risk involved when selecting and financing a car and to minimize that risk as much as you can. Gap insurance can help with this. Like other types of insurance, although you hope you won’t ever need it, having it provides peace of mind and financial relief should the unexpected occur.

Hopefully this article helped take the guess work out of whether or not purchasing gap insurance makes sense in your specific situation.  

Are you looking for more insurance 101 tips?  Read more here.

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Disclaimer: This article is intended to be informational in nature. It may not be current and is subject to change without notice. Please contact your agent or carrier for your specific coverage implications.