As it pertains to cars, gap insurance covers the difference between what you owe on your car loan and the actual cash value of your car if it’s totaled in a crash. That “gap” can amount to quite a bit of money, which you’d otherwise have to pay out of your own pocket — particularly if you didn’t put much money down when you bought the car (less than 20% or so) or took out a long-term loan (say, for more than five years). While the cost of gap insurance varies widely with the car, it can often be had in the $20-$60 per year range, and you typically only need it for the first few years. Here’s how to determine if you need gap insurance for your vehicle.
Related: What Is Gap Insurance?
Should I Get Gap Insurance?
If you owe more on your car than it’s worth, it’s called being “upside down” or “underwater.” This can happen very easily because a new car tends to depreciate quite a bit in its early years. Furthermore, if you took out a loan with interest, a disproportionate amount of your early monthly payments typically goes to paying off the total amount of interest owed over the length of the loan rather than paying off the principal on the car. (Toward the end of the loan, it reverses.)
For many people, gap insurance only makes sense for the first few years of ownership while they’re paying off a loan. Eventually, the amount you’ve paid toward the principal will have reduced the amount you still owe to less than the car’s value, eliminating the need for gap insurance.
For instance, if you took out a $20,000 loan on your car and paid off $12,000 in principal — leaving $8,000 to go — and the car is worth at least that same $8,000 if it’s totaled, you no longer need gap insurance. However, it’s important to remember to subtract the amount of your deductible from what the insurance company says is your car’s value, as that deductible could easily be $500-$1,500 or more. In the example above, if you have a $1,000 deductible and the value of your car is $8,000, you may want to keep your gap insurance until you have $7,000 left in principal.
The chip shortage has limited the number of new vehicles that can be built, which greatly increases the cost of new cars and the value of used ones. That’s good if you bought a car before prices went up, but if you bought a car after prices went up — and took out a loan for it — that could put you in a bad position when car prices drop back to normal. This would be a prime example of when it could be a good idea to get gap insurance.