How gap insurance works
Like many other insurance products, gap insurance is correctly titled. Its primary purpose is to fill in "gaps" between the value of the asset being insured and your remaining obligations created by its loss in the event of an accident or disaster. Here is a simple example that should explain how gap insurance works.
You purchase a new auto for $27,000. You make a down payment of $1,000 and finance the remaining $26,000 over five years using dealer financing or a bank, or credit union new auto loan.
You properly insure your shiny new car and opt for a $500 deductible on losses. You decline to buy gap insurance coverage. In six months, you have a terrible accident. Wearing your seat belt, you were not seriously hurt. However, your car suffered terminal injuries and is a total loss.
Your friendly car insurance company adjuster determines that your formerly shiny new auto is "totaled" and ready for metal recycling. He/she cheerfully advises you that your company will give you 100% of your car's retail book value minus the $500 deductible in your policy. The "book" states that your auto has a fair market value (FMV) of $23,700 today. They will give you a check for $23,200 right away.
But, wait, you advise them. I still owe $24,800 on my auto loan. Unfortunately, your insurance company will understand your dilemma, but can only offer you book value minus your deductible. These are the terms of the auto insurance coverage you chose to purchase. You'll have to find another $1,600 somewhere just to get back to even.
However, if you had also purchased gap insurance, the result would be different. After being advised that your company will send you a check for $23,200, you file a claim under your gap insurance policy.
You will quickly receive a check for either $1,100 or, if you selected a policy that covered your deductible, a check for the full $1,600 you are short. The "gap" between the value of your asset (auto), and the outstanding loan you have against it, will go from $1,600 to $0.
Why gap insurance is a good choice in many situations
In some situations, gap insurance may not be necessary, but in many others it is a good option. The seemingly constant increase in new and previously owned auto prices has made gap insurance a money saving option for many car buyers.
Everyone wants to "get a deal" when buying a car, but reality has a way of showing itself when you least want or need it. The way most autos depreciate is annoying at best and costly in many situations. You should become familiar how this process typically works.
New and previously owned autos sell for a price that you and the dealer agree upon. Typically, the price will be somewhere close to the retail book value.
Unlike some other assets, the largest depreciation (reduction in fair market value) of an auto occurs in the early, not the late years of the car's life. Since many owners keep an auto for only two or three years, this level of depreciation can sometimes pose problems.
Should you experience a major or total loss through moving accident, theft, fire, or other covered event resulting in a total loss, you often find that your outstanding loan balance is larger than your auto's fair market value. In addition to your obvious disappointment in losing your vehicle, you might owe your auto lender thousands of dollars for a car that no longer exists.
If you have purchased gap insurance you'll breathe much relief and consider your choice for this coverage as one of your better decisions. After receipt of the funds for your lost insured vehicle, you'll learn how far "under water" you are with your auto loan.
Filing a claim through your gap insurance policy should result in having the funds to pay off your outstanding auto loan in full. You can then shop for your next auto without fear of starting your new car financing in the hole.
Why gap insurance is not for everyone
Gap insurance is not for everyone. If you typically make large down payments for your auto purchases or are part of the growing market of buyers who favor buying lower cost, but still attractive and serviceable previously owned cars, you may not need this extra coverage. As beneficial as gap insurance can be, like most other coverage, there is little need to be over-insured.
The chances of ever collecting claim dollars are slim, often non-existent. But, for those who enjoy the newest autos with all the toys from GPS to Sirius radio, gap insurance may be a wonderful insurance protection option.
