GAP car insurance, do you need it?

If you’re looking to save money when buying a car, consider not purchasing gap car insurance (also called gap protection).  Many websites (and of course the Finance Department at a car dealership) will try to scare you into thinking it’s a necessity, but I try to provide a more objective opinion.

Salesmen will tell you that the moment you drive off the lot your insurance is probably inadequate to cover you in the event of a total loss.  But don’t let the let this frighten you into spending money without considering whether you really need to.

What is GAP insurance?

When you buy a new car, it depreciates quickly within the first few years.  During this time, it’s possible to owe more on your car loan than the value of the car.  This is called being upside down in a loan.  There is a negative “insurance gap” between the amount you owe and your vehicle’s worth.

If your car is stolen or totaled in an accident while you are upside down, it’s possible that your insurance payout may not cover the balance left on your loan.  Remember, insurance payouts are based on the car value, they have nothing to do with your loan.  That’s where GAP insurance comes in.  GAP insurance will pay you the shortfall, meaning the difference between the actual cash value of the vehicle and the current outstanding balance on your loan.

Why should you consider skipping the GAP insurance?

Like all insurance, car gap insurance is a premium you pay to hedge against future risk.  You’ll spend a few hundred bucks now to protect yourself from the possibility of owing a thousand or two later.  But like all insurance, you have to assess whether avoiding risk is worth the premium.

Consider the cost of the insurance versus the amount of the payout and the likelihood that you will need it.  For example, if a gap policy costs $300 and your likely payout is $2000, you’re wagering 15% of the potential payout to cover your risk.  Do you think there’s a 1 in 7 chance of totaling your car?  If not, it’s probably a high premium to pay.   And keep in mind, regular car insurance covers the cost of repairs for a majority of accidents.  Your car must be completely totaled for gap insurance to even come into play.

Not only that, but if you buy a gap insurance policy from the dealership you’ll probably pay more because they will include a profit margin for themselves.

Also, if your existing insurance policy covers “full replacement cost” or “fully financed amount”, then you do not need additional GAP coverage.

How to avoid needing GAP car insurance?

The real question should be how do you avoid becoming upside down in a car loan.  Here are a few tips:

  • Borrow as little as possible.  Did you know it’s possible to finance more than the cost of the car?  This can happen if you roll over a balance from a previous loan or include tax, tag, warranties, and add-ons in your loan. Try to avoid this temptation and put up a reasonable down payment (if possible aim for at least 20%).
  • Avoid longer loan terms.  A longer loan means you build equity more slowly (aim for 5 years or less).
  • Get competitive financing online.  Using dealer financing or poor credit could both be reasons for a high interest rate.  You want more of your money to go towards principal, not interest.
  • Avoid rolling negative equity from an old loan into your new loan by paying it off before buying.
  • Don’t overpay for a vehicle.  The more you reduce the price of your new car, the easier it will be to pay it off.
  • Consider cars with higher residual values when buying.  The faster a car depreciates, the more at risk you become. To see the five-year depreciation schedule for any new or used car, check out Edmunds’ True Cost to Own.)

If being upside down in a loan is unavoidable, consider whether you’re willing to accept a little risk.  If your car was totaled, could you survive for a few months sharing a car or replacing it with a cheaper car that allowed you to finish paying off your old loan?

If you decide you still want to get GAP insurance, look around online at a place like esurance, rather than the dealership where the premiums will be marked up.