Something that the recent housing market crash has shown us all is that there is a definite difference between a property’s cost and its market value. When the housing market tanked and market values sharply declined, many of the mortgages and loans on the houses were more costly than the houses could be sold for. The term for this is being “upside down on the loan”. A similar issue can occur with auto insurance coverage, so it is something that you need to watch out for.
Similar to the housing crash, new cars often depreciate faster than the auto loan is paid off. This is especially true since early loan payments on a new vehicle are almost entirely interest. The issues arise if the car is totaled before the loan is paid off enough to where it is less than the actual cash value of the car (price new minus depreciation).
Let’s use a hypothetical situation to describe why GAP Insurance is necessary; the graph below illustrates the example. If Ashley buys a new car for $16,000, but takes out a loan with a total interest of $4,000, then she has a $4,000 deficit when she signs the paperwork to buy the vehicle. Let’s also assume that she elects to pay off the cost of the car in equal payments over the course of three years. Since the vehicle depreciates very quickly at first and then slows down (shown by the red line), this deficit will remain, first getting slightly larger and then shrinking to zero by a few months into year 2. During this time, if the driver totals the car and the insurance company pays the driver the Actual Cash Value amount of the car (which it always does unless otherwise specified in the policy), then the driver will still have to pay off the remaining amount due on the auto loan above what the car is determined to be worth by the insurer.
To avoid this, GAP (also called Guaranteed Auto Protection) insurance can be purchased or added to the policy. If GAP insurance is in effect, the insurance company will pay off the deficit amount, and occasionally the deductible for the collision as well, leaving the insured driver with no financial loss. A common mistake is to assume that the insurance company will pay off any remaining car payments left, so don’t fall into this financial trap.
Some additional things to keep in mind for GAP coverage are: it only covers a complete loss not non-totaled vehicle repairs, it applies only to the losses that are explicitly covered by your auto policy, and not all GAP policies will cover the collision deductible. Overall, this is an important extension of your car insurance to look into if you are buying a new or recent model-year vehicle, however this sort of policy is unnecessary for older vehicles since the depreciation rate slows substantially after the first few years. We recommend comparing your loan payoff schedule to the Kelly Bluebook value of your vehicle over the first few years to determine the length of time that this coverage is worth the investment.