What is gap insurance?

If you're leasing or financing a new car, many lenders require you to have collision and comprehensive coverage on your car insurance policy until your car is paid off.

Gap insurance is meant to be used in conjunction with collision coverage or comprehensive coverage. If you have a covered claim, your collision coverage or comprehensive coverage would help pay for your totaled or stolen vehicle up to its depreciated value. When you drive a brand-new vehicle off the lot, it loses 20% or more of its value in the first year, according to Kelly Blue Book (KBB).

But what if you still owe more on your loan or lease than the vehicle's depreciated value? That's where gap insurance may help.

Here are some common scenarios when someone should consider gap insurance –since gap insurance coverage is designed to help pay off a car loan if the car is stolen or totaled, and more is owed on the loan than the car is worth.

Small or no down payment

If you’re financing a large portion of your car, you may owe more on the loan than the car’s Actual Cash Value or ACV (the value your insurance company will pay under collision or comprehensive coverage). Car depreciation varies from car to car, but most new vehicles can drop 20% in value within the first year, states KBB. So, if you put a down payment of 20% or less on your new car, chances are you may owe more than it’s worth.

Financing for a longer term

If you have a car loan that’s longer than five years (60 months), your monthly payments reduce the principal balance you owe at a very slow rate (especially in the beginning, you pay much more interest than principal). This means that your car’s depreciation will likely outpace the equity you’re paying down with your loan.

Leasing a vehicle

Many lease agreements payments are based on the predicted depreciation of the car over the lease term. The amount you’d owe on the car if the lease terminates early (due to a total loss) often exceeds the car’s ACV, explains the Federal Reserve. In fact, many leasing companies require gap insurance coverage in the lease contract.

Buying a car that depreciates quickly

Certain makes and models of cars lose value faster than others. If you purchase a car known to depreciate faster, the risk of owing more than it’s worth can be higher. High-end luxury cars often depreciate the most, says Investopedia. They associate this with features and technology that used car buyers may not always value.

Here's an example of how gap insurance may work: Say you bought a brand-new car for $25,000. You still owe $20,000 on your auto loan when the car is totaled in a covered collision. Your collision coverage would pay your lender up to the totaled car's depreciated value — say it's worth $19,000. If you don't have gap insurance, you would have to pay $1,000 out of your own pocket to settle your auto loan on the totaled car. If you have gap insurance, your insurer will help pay the $1,000.

Keep in mind that, in the above scenario, the car insurance reimbursement goes completely to your auto lender to pay off a car that's no longer drivable. If you think you would need help buying a new car after yours was totaled, you might want to consider purchasing new car replacement coverage. Some insurers sell loan/lease gap coverage and new car replacement coverage together, as a single add-on to a car insurance policy for a brand-new vehicle.

You may be able to get gap insurance after you buy a car, depending on the model year of the vehicle. Gap insurance isn't just sold at car dealerships — many insurers offer gap insurance as part of a car insurance policy. And, according to the Insurance Information Institute, buying gap coverage from an insurance company often costs less than buying it from a car dealership.

Some insurers require your vehicle to be brand new for you to purchase gap insurance. That may mean:

• That you are the original owner of the vehicle (you have the original lease or loan on the vehicle)
• That the vehicle is not older than two or three model years

Check with your insurer to see what qualifications are required for you to buy gap insurance.

If you're considering buying gap insurance, it's important to remember that this type of coverage may only be available if you're leasing or financing a new vehicle. Then, think about how much you’ll owe on your auto loan versus the value of your car. You can get estimates of what your car is worth by checking a site like KBB. What would your car be worth if it was totaled in the first year? The second year? The third? Could you afford to pay the difference out of pocket?

If the financial burden of paying the difference between what you owe on the car and the car’s ACV is a significant amount, gap insurance coverage may be worth it for you.

Have more questions about gap insurance? Talk to your insurer, who can help explain your options.