Car Insurance

What Is A Gap Contract When Buying A Car

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 5 minute read

It’s possible that purchasing a new vehicle is the worst financial decision you can make. Why? When you drive off the lot in your brand-new car, its value instantly drops by 15% to 20%. The depreciation in value is not unique to brand-new vehicles; it occurs just as rapidly in older vehicles.

It’s highly improbable that, during the course of a car loan’s repayment period, the vehicle’s value will increase to cover the loan’s principal. Most people have automobile loans that are significantly higher than the value of their car, whether it’s brand new or old (known as being upside down). 

This can have disastrous financial consequences in the event of an accident. To perhaps prevent such a catastrophe, gap insurance could be the answer.

How Does Gap Insurance Work?

Gap insurance fills in the “gap” between your insurance payout and your loan balance in the event of a catastrophic loss. The purchase price of an automobile is usually higher than its subsequent worth on the used market. 

Furthermore, if you financed your vehicle purchase, you probably incurred additional charges that are non-refundable, such as sales taxes, title fees, emission fees, and registration.

As soon as you drive off the lot, you could be in the red on your auto loan depending on how much of a down payment you made. That predicament can become catastrophic if your automobile is totaled and you receive a payout from your insurer that is less than the amount remaining on your car loan.

Let’s pretend your down payment on a $27,000 car is $2,000. The insurance company may only value it at $18,000 to $19,000 shortly after you buy it, depending on criteria like the car’s condition, price surveys, and industry guides like Kelley Blue Book.

Therefore, even if you total your automobile and collect the maximum reimbursement from your insurance policy’s collision coverage, you may still be left with a loan outstanding of $7,000.

Do You Require Gap Insurance?

Naturally, not everyone is a candidate for gap insurance. However, there are circumstances in which gap insurance is especially important:

  • Gap insurance is useful if you finance a high-depreciation car. Depreciation occurs rapidly for most automobiles, but at a far faster rate for specific models.
  • In the event of a catastrophic loss, gap insurance may provide some additional financial security if you have financed your vehicle for longer than four years. Your loan-to-value ratio will improve with a shorter financing period. That is to say, the “gap” between your car loan and the car’s value will close and diminish considerably faster with a shorter loan period.
  • It’s possible that you owe more on your automobile than it’s worth if your down payment was less than 20%. Gap insurance is designed to cover the difference between what your automobile is worth and what is still owed on your loan in the event of a catastrophic loss or theft.
  • In the event of a total loss, gap insurance can be useful if you financed the purchase with a portion of the loan balance from another vehicle.
  • When leasing a car, you may be forced to have gap insurance.
  • Gap insurance is useful for drivers who put on more than the typical yearly mileage of 15,000 miles. High-mileage autos lose value more rapidly than others.
  • If your household only has one vehicle, you likely can’t go without transportation for very long. In the event of a catastrophic loss, gap insurance can assist protect your loved ones financially.

If you know for sure that your loan-to-value ratio won’t leave you underwater on your auto loan in the case of a total loss, then you probably don’t need gap insurance.

What is the Price of Gap Insurance?

Your annual cost for full coverage and collision insurance plus about five percent is the average gap insurance rate. These costs might fluctuate widely depending on factors including the market value of the car, the area in which the policyholder resides, and the policyholder’s driving record.

Comparatively, if you pay $600 per year for comprehensive and collision insurance, your gap insurance rate will probably be approximately $30.

How to Purchase Gap Insurance

Buy from a Broker, Not a Dealer

Gap insurance is something that can be purchased via the dealership, your financing company, or an independent insurance agent. It is recommended that you do not get this insurance from the dealership where you bought your vehicle. Car dealerships often charge up to four times the market cost for gap insurance.

Instead, you should consult with your insurance broker or an independent insurance provider to obtain a price for gap insurance. You should get gap insurance as soon as possible after getting a car loan. If you can wait until you have access to a vehicle, seeing your insurance agent in person could save you hundreds of dollars.

Be Certain to Receive a Refund

During the time that you have a loan, your gap insurance will pay for any costs that arise. When your debt is paid off, you can cancel this policy.

As an added note, the payment for gap insurance is typically paid upfront or rolled into the loan. If your monthly cost for gap insurance is $10 and your auto loan term is 72 months, you may be required to pay the full $720 at the time of purchase or add it to your loan balance.

However, keep in mind that you should be entitled to a return if you sell or refinance the vehicle before the loan term ends. The payment for your gap insurance will be prorated throughout the course of the loan, even if you paid it all at once.

Your insurance company owes you $360 if you paid off, sold, or refinanced your car three years after purchasing a policy with a total cost of $720 over 72 months but only used 60 of those months. 

The insurance company should promptly issue this reimbursement after being informed of the sale or refinance. Still, in other cases, car lots either forget or refuse to issue the refund unless the client follows up.

It is important to remember to purchase gap insurance for your new policy if you refinance your automobile.

When to Avoid Buying Gap Insurance

While there are many cases in which a car owner may benefit from having gap insurance, there are also many in which doing so would be a waste of money.

Some typical cases when you might not need gap insurance include:

  • There’s no need to get gap insurance if your car’s value is significantly more than the loan and your insurance company’s total loss payout would cover the difference.
  • You do not require gap insurance if, in the event of a catastrophic loss, you would be able to either maintain current loan payments or pay off the loan in full.
  • You don’t need gap insurance if you don’t plan on replacing your car in the event of a total loss.
  • You don’t need to get gap insurance if your loan is for a short length of time, like six months to a year.

Bottom Line

Owning a car comes with a hefty price tag. Many customers balk at the prospect of shelling out an extra $15 per month on top of their standard comprehensive and collision coverage after seeing their principal and interest payments.

Even so, gap insurance is typically a must-have if you plan to finance your vehicle purchase. Without it, you can end up with a costly car loan on a car you can’t even drive.

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