Gap Insurance and Upside Down Auto Loan

I was introduced to Gap Insurance when I bought my new Honda Element in December 2005. Gap Insurance is an insurance product designed specifically for buyers who purchase their new car with financing — in other words, those who will be upside down on their auto loan.

upside down autos

Photo by Lyle58 via Flickr

What Is An Upside Auto Loan?

When you take out an auto insurance policy, the insurance company will pay for the repair cost or the fair market value of the vehicle (whichever is lower). However, the fair market value could be lower than what you owe on your car loan due to depreciation. Here’s an illustration of the concept.

From the illustration above you can see that new cars depreciate quickly and there is a period where you owe more in car loan than the car is worth. This is what the industry call “Upside Down Auto Loan“.

What Is Gap Insurance?

The purpose of Gap Insurance is to pay for the difference between the value of your car and what you owe in car loan. For example, let’s say you totaled your car after 15 months. At this time, you have $23,000 left on your car loan, but the insurance company determines that your car only worth $19,000. As a result, you will have to come up with $4,000 on your own to pay off the financing company. However, if you have a Gap Insurance, it would pay the $4,000 difference to the financing company.

Commonly Asked Questions About Gap Insurance

Where can I buy a Gap Insurance?

The best place to start is with your current car insurance company. Although your car dealership will try to convince you to buy a Gap Insurance through them, you’ll most likely pay a higher premium for the same coverage that you can get elsewhere.

Should I get a Gap Insurance?

Whether or not you should get a Gap Insurance is really up to you. However, there are a few factors that you should consider:

The amount you are financing. If you made a large down payment on the car, you may never be upside down and will not need a Gap Insurance. However, if you go for the $0 down payment deal, there’s probably a large gap between what you owe and what the car is worth.
The average depreciate rate of your vehicle. Some cars hold their values better than others. Depending on the car you purchased, the gap may be larger or smaller depending on the depreciation rate of that specific car. For example, Japanese and German cars depreciate much slower than American cars.
Your ability to pay for the difference in case the need arises. If you can cover the gap with your own money, you could very well skip the Gap Insurance and save yourself a few dollars each month. However, this is a calculated risk because even the best drivers do get into accident.

Is Gap Insurance required?

No, Gap Insurance is not required. However, the financing guy at the car dealership will do his best to convince you otherwise.

Do I need Gap Insurance for my leased car?

This depends on the leasing company. You should ask the car dealership regarding who would be responsible for the difference if the amount paid by the insurance company were not sufficient to cover the lease. Usually, the lease has this insurance built in, but it’s safer to ask anyway.

How To Avoid Being Upside Down On A Car Loan

There are many ways to avoid being upside down on your car loan. Money Crasher highlighted a few ways as follow:

Don’t finance a car.
Treat a car purchase like a house — i.e., plan to make at least 20% down payment.
Pay more than the specified monthly payment.
Keep the car well maintained.

And I would add these to the list:

Drive safely and defensively.
Buy used car instead of new.

Here are some great articles about buying a used car:

Buying a used auto with high miles at Gather Little By Little
Most Reliable Used Cars at Single Guy Money
Used Car Buying Guide for Teenagers at Frugal Dad
Seven Tips For Buying a Second Hand Car and Walking Away Happy at Wise Bread

What’s your experience with Gap Insurance? Please share…

17 Comments

David
August 21, 2008, 10:29

I definitely buy Gap insurance when we finance a new car, after a friend of mine got hosed when he totaled his 4 week old BMW – and owed THEM money. It’s a small price to pay for a big piece of mind.
Jason
August 21, 2008, 11:02

I like the idea of buying specific insurance, or beefing up your emergency fund, to cover the gap. Better yet, stick to late model used cars so the deprecitation doesn’t outpace your declining loan balance. Great advice, and thanks for including my article.
MoneyGrubbingLawyer
August 21, 2008, 14:59

Gap insurance is definitely worth it. The additional cost is usually minimal, but it gives you quite a bit of protection.
Interestingly, gap insurance is why I recommend that people never put money down on a leased vehicle. If you finance a vehicle and it gets written off while you are upside down, gap coveres the difference. If you have equity in the vehicle and it gets written off, you get any money that’s left after the finance company is paid. However, with a leased vehicle, insurance (with gap coverage) will only ever pay out the amount owing under the lease, regardless of whether you reduced that amount with a downpayment.
FFB
August 21, 2008, 15:09

Nice definition of GAP insurance. I have to look through my papers for my new Honda Odyssey. I feel like Honda offered free GAP insurance. This also proves that I have to pay a little more attention!
Jerry
August 21, 2008, 17:01

I should’ve gotten gap insurance for our 2nd car. We had a Volvo and a Hyundai and the Volvo retains value a heck of a lot longer than the Hyundai. Thanks for the info! Next time I buy, I’ll get the insurance. It will definitely lead to peace of mind.
Single Guy Money
August 21, 2008, 20:38

Thanks for the mention! Since I don’t plan to finance another vehicle, I hopefully won’t need GAP coverage.
Pinyo
August 22, 2008, 17:53

@David — Wow, that’s suck for your friend. I hope he’s alright.
@Jason — My plan is to stick with used car from now on. It makes a lot more sense. However, nice off-lease used car may be hard to come by in the future if manufacturers are dropping their lease programs.
@MoneyGrubbingLawyer — Very interesting approach to go with $0 down and gap insurance. Definitely a clever way to reduce your potential loss.
@FFB — I don’t think Honda offers free gap insurance. Mine was being sold separately. You may want to check your document carefully. It’s possible that the dealer bundled in the insurance premium with the monthly payment without pointing it out to you.
@SGM — Sounds like a plan!
Dave
January 16, 2009, 15:04

Where’s the line on whether you need gap depending on how much you put down? 10%, 20%, etc? I put 20% down – do I still need gap?
Pinyo
January 16, 2009, 15:34

@Dave – The way to calculate it is see how much you owe and compare it to the blue book value of the car (or you can call the insurance company to get the current replacement cost).
JCHIS EST
February 16, 2009, 20:43

I am so glad I found this article. Just yesterday I decided to read every word of my paperwork from a recent used car purchase. I was so tired of getting turned down for financing that when I was finally told I would be financed, I just went with it. I bought an Isuzu Rodeo, 1999, with 147,000 miles. The dealer told me that since the miles were high he would give me a 2 year warranty. Here I am, thinking back and cringing because I was thanking him like he was such a great guy. When I actually read through everything yesterday, I found that I paid over 2500. for that warranty and I was sold gap insurance also. I didn’t understand what gap ins was, but I think that since my 4700. car, ended up totaling 10,000. with financing costs ,warranty, and gap, I will need it. Can I drop the warranty they sold me and find my own?
Pinyo
February 16, 2009, 21:32

@JCHIS – It will depend on the term of the warranty. I was sold a warranty with my new Honda a few years ago. Luckily, I was able to go back and cancel it. However, I did it fairly quickly after the sale. I am not sure about your situation.
Tom Vlasic
February 21, 2009, 15:43

Can someone please direct me to a company where I can purchase a stand alone Auto Loan Gap policy? Carmax, Wachovia Bank, and my insurance company do not offer Gap.
No Gap
February 22, 2009, 19:04

I hate Gap insurance. I had my F150 stolen after 18 months. I did the zero percent 60 month loan so I put down no money even though I could have. I refused the gap insurance (I had cash in bank).
After 16 months the truck was stolen, a total loss. Remember, this is a fast depreciating vehicle purchased with no money down. The long story short, I was underwater by only <900 dollars. Gap would have helped here, but I also needed 1000 for the deductible and 2500 for the tax and fees on my next truck.
The gap would have only saved me 900 bucks out of the total of 4400 dollars. Even if it is 25 bucks a month, I would rather pay the insurance premium to the principle.
Pinyo
February 23, 2009, 22:44

@Tom – I am not sure where to go, usually they are offered through your financing company. You can try checking out OwnerGuard (http://www.ownerguard.com/Type.....rotection). I don’t know them and I don’t use them. They just happen to be the name I have on my GAP waiver form.
@No Gap – I just bought a car and waived the GAP insurance too. I like your idea of using that to pay down the principal…not bad.
Jim Galle
May 2, 2009, 11:31

Can you use gap insurance if you want to sellit while upside down?
Hazel
June 12, 2009, 15:28

My vehicle recently caught on fire! There was some sort of an electrical short and the engine blew up. My insurance company is now investigating my claim, but I am farily certain it will be considered a total loss. My question is, I currently owe more than the vehicle is worth. Thankfully, I did purchase gap insurance, however do you think the insurance company will pay off my loan? Due to the fact that I wasn’t in any accident???
Pinyo
June 12, 2009, 15:34

@Hazel – I am sorry to hear that. The insurance should be paying you for the fair market value of the car assuming you have proper insurance (i.e., comprehensive as opposed to collision). If you purchased gap insurance, then that insurer should pay you the difference between what you get from your auto insurer and the remaining amount of the loan.