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.

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:

1. 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.
2. 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.
   
3. 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…