How Does Gap Insurance Work? Car Loan Protection Explained

Imagine you're still paying off your new car loan when an accident totals your vehicle. Will your insurance cover the rest of the loan? You may have financial protection in this situation if you have a gap insurance policy.

What is gap insurance, and how does it work? Explore the ins and outs of gap insurance in this guide to help you decide whether you should purchase this coverage.

What Is Gap Insurance?

Gap insurance, short for Guaranteed Asset Protection, is a type of car insurance that covers the difference between the current value of your vehicle and the amount you have remaining on your loan or lease.

So how does gap insurance work if the car is totaled?

For example, say you buy a new car worth $25,000 with a $22,000 loan. After 2 years, your car has depreciated to a current value of $16,000, but you still owe $18,000 on the loan. If your car is totaled, your traditional car insurance coverage will only pay the $16,000 actual cash value, leaving you with a $2,000 gap to pay off the rest of your loan. That’s what gap insurance is for.

Gap insurance makes it possible to pay off your remaining car loan or lease without dipping into other savings. It prevents you from having to pay more than your car is worth out of pocket, even after it depreciates.

What Does Gap Insurance Cover?

Like any other car insurance, gap insurance only covers specific incidents, such as theft and accidents that total your vehicle. It may also cover:

• Natural disasters that total the vehicle
• Vandalism
• Fire

Your traditional car insurance still covers the cost of replacing or repairing your vehicle after a covered incident. The gap insurance only covers the difference between how much your vehicle was worth and the remaining balance on your loan.

Keep in mind that gap insurance does not pay for your deductible for your traditional car insurance. It also does not cover repairs, missed loan payments, or the initial down payment you made on the vehicle. And if you refinance a car loan, you may void your gap insurance coverage.

Who Needs Gap Insurance?

Gap insurance is optional car insurance coverage, so you can decide whether it’s right for you. Generally, new car owners benefit most from gap insurance because vehicles depreciate fastest in the first few years. Having an upside-down loan — owing more than the car is worth — is much more common with new car purchases, and that’s when gap insurance applies.

For the same reason, you’re more likely to need gap insurance if you’re making a low down payment on a vehicle that will depreciate quickly. The faster your car depreciates, the bigger the gap between its actual cash value and your loan balance could be.

Leaseholders are also likely to benefit from gap insurance coverage. Your lessor may even require you to purchase it. How does gap insurance work for a leased car? If you total a leased vehicle that depreciated quickly and still owe a large balance on your remaining lease, your gap insurance will make sure you don’t end up having to cover that whole difference out of pocket.

How To Purchase Gap Insurance

There are a few different ways to purchase this insurance. You can go through traditional car insurance companies, such as the provider of your collision or comprehensive coverage, but that’s not your only option.

The car dealership where you purchase or lease your vehicle may sell gap insurance. How does gap insurance work through a dealership? The dealer is likely to offer you this coverage as an add-on product to your purchase. Or the company lending to you may sell gap insurance to go with your car loan.

Don’t just select the first gap insurance policy someone offers you. Make sure you compare prices and the policy terms to find the best deal. These factors affect the cost of your gap insurance:

• The value of the vehicle you’re buying or leasing
• The duration of your loan (e.g., 36 months, 48 months, or 60 months)
• Your loan amount

Generally, the more expensive your vehicle is and the longer your loan is, the more expensive your gap insurance coverage will be.

How To Determine If You Need Gap Insurance

If you’re on the fence, ask yourself these questions to determine whether you need gap coverage:

• Does your lender or lessor require it?
• How quickly does the vehicle you selected depreciate?
• Could you afford to cover the difference out of pocket if your financed vehicle was totaled with an upside-down loan?

You can find estimates of how quickly your specific vehicle will depreciate online. Use that information to determine how large the gap between the vehicle’s actual cash value and your remaining loan balance might be at any given point, especially during the first few years of owning the car. If that difference is too large for you to cover out of pocket, you may need gap insurance.

Alternatives to Gap Insurance

You have other options, such as new car replacement coverage. If you total your new vehicle under this policy, your auto insurance company will pay you enough for you to buy a brand-new car. The depreciated value of your totaled new car doesn’t come into play.

There’s also loan/lease payoff coverage. This type of lease gap coverage pays a set percentage of your vehicle’s actual cash value toward paying off the loan or lease if it's totaled or stolen.

How To Make a Claim: Basic Guidelines

If you need to make a gap insurance claim, follow these steps:

1. Contact your gap insurance provider.
2. Gather necessary documentation such as your loan contract, insurance settlement statement, and possibly a police report from the collision or theft (if applicable).
3. Follow your gap insurance provider’s instructions for submitting your claim with the required documents either online or by mail.
4. Wait for your provider to process your claim and pay you your benefit amount. Continue making minimum payments on your auto loan in the meantime. 

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