I have had many questions on the issue of gap insurance in the past and never really found a satisfactory answer. The most common answer to the question: “What is gap insurance?” - something that a car salesman or a website will give you - is this:
Gap insurance closes the gap between what your auto insurance company thinks your car is worth (if your car is stolen or totaled) and what you owe the finance company.
Now, technically, that is a correct definition, but it doesn’t really help you visualize the concept very well. Plus, such a definition doesn’t help in answering any other related questions on gap insurance; for example, “Do you need gap insurance on used cars?”, “Do you need gap insurance on leased cars?”, “In what other situations is this insurance not necessary?”, etc.
In this post, we will try to visualize the idea of gap insurance with the help of some graphs, and then try to extend it to various situations to address other commonly asked questions about gap insurance.
- What exactly is the “gap”? and why does this gap needs to be insured?
Let us follow a hypothetical purchase of a 2007 Buick Terraza, one of the worst depreciating vehicles out there. The high depreciation of this vehicle will allow us to see the “gap” clearly. Here is how the value of this vehicle depriciates over time (data from Edmunds.com):
The values in the table above are what insurance companies are going to follow for a *regular* insurance. So, if you total the car within a few days after driving it off the dealer’s lot, you will get only about $24,190 from the insurance company. If you total it after Year 1, you will get $19,860 and so on.
Now, let us assume that you financed this vehicle with $0 down and 6% APR auto loan for 60 months. Your monthly payments (according to Bankrate.com) will be $623.54. Based, on this monthly payment, and accounting for the interest per year, here is how the amount you owe the financing company will look like:
Now, let us plot these values together to get the following graph and observe how the gap looks like.
The shaded portion is the “gap” in the term “gap insurance”. This is the gap that needs to be insured. For example, if you total your Buick Terraza after the 1st year, your regular insurance will give you only $19,860, whereas, your financing company will ask you to shell out $26,551 to clear off your debt. There is a gap of $6,691 between these to figures and you need gap insurance if you don’t want to pay this gap amount.
- How does the gap look when you lease a vehicle?
You saw above that financing the car (at 6% APR) created a gap of $6,691 after the first year. Instead, if you had leased the vehicle, for say 60 months (usually, it’s less than 60 months, but this will help us understand it better) , your monthly payments would have been much lower (probably around $350 ?) - which means that you would have owed more (than the financing option) after the first year, and therefore the gap would have been larger. This is shown in the graph below.
Also you can see that the gap exists for the entire period of the lease. That’s why you MUST have gap insurance at all times when you are leasing a vehicle.
Another point to note is that the *residual value* as defined by most leases is usually higher than the actual depreciated value of the vehicle. This will be the case, whatever the length of your lease is. This means the gap will ALWAYS exist for a leased vehicle.
- Do you need gap insurance if you are financing a used vehicle?
From the above graphs, it is obvious that the gap is maximum when you just drive off a dealer’s lot with a brand new vehicle and then it gradually decreases over time. It eventually goes to zero within a few years (3 years in the above example).
Generally, gap insurance won’t be offered on used vehicle at all; but just in case it is being offered (people can offer you anything to extract money from you), you won’t really need it for vehicles that are more than a few (2 ~ 3) years old. Depreciation slows down after the first year, and in all probability, for a vehicle that is about 3 years old, your monthly payments will be more than the loss in the vehicle’s value. So, you will never hit a point where you owe more than the value of your vehicle (or more than what your regular insurance will pay you).
The only exception to this is when you have been sold a used vehicle for a price that’s way above it’s depreciated value (not a good deal to begin with) - and you completely financed it without any down payment. At that time, for a brief initial period, you will be owing more than the value of the vehicle.
- Are there any cases in which you may not require gap insurance EVEN if you finance a new vehicle?
Yes. Depending on the term of you car loan and your initial down payment, it is possible that you may not require the gap insurance on a financed new vehicle. Let’s discuss two simple cases below.
- Case 1: You make a large down payment. For the example above, suppose you made a 25% down payment and availed an auto loan for just $24,190. You are essentially taking care of most of the initial depreciation. In this case, you will probably never owe more than what your regular insurance will give you if you total your car. This is shown in the graph below.
- Case 2: You make a small down payment and your loan term is very short. In this case, the gap is small and is very rapidly reducing towards zero. You will be taking some amount of risk, but it will be a very short term risk. For our example of the Buick Terraza, this is shown in the graph below for a 10% down payment and a 24 month loan term. The gap reduces to zero in less than six months.
- Do you need gap insurance if you buy a vehicle using cash?
It is important to note that the gap is essentially defined ONLY if you are financing (or leasing) a vehicle. If you are using cash, you don’t owe anything to anyone, and there is no gap and hence, gap insurance doesn’t hold any meaning. This is how the graph looks like when you pay cash for a new vehicle:
What other things should you look out for when choosing a gap insurance?
- First issue - you don’t really need gap insurance for very long periods of time if you are financing your vehicle. It depends on your loan terms and conditions. In the above example, you need gap insurance for only about 3 years. If your loan period is longer (72 months or 84 months), or if you are buying a vehicle that’s worse in terms of depreciation, then you may probably need a slightly longer coverage. So keep that in mind before you jump for the longest coverage.
- Second important issue - watch out for the deductible. If the gap insurance has very high deductible, then it essentially defeats it’s own purpose. The purpose is to protect you from shelling out a large sum of money for a car that has been totaled (or stolen) ~ so that you would have enough cash in hand to arrange for an alternate vehicle if you need one. High deductible defeats this protection. Plus, sometimes (in case of cars that depreciate very slowly) the cost of the gap insurance and the deductible together might be greater than the gap itself. Beware of such situations.
- Of course, before you buy a separate gap coverage, you also need to make sure that it is not covered by your existing insurance company and/or included in the lease payments itself.
Hopefully, things are clearer by now. Remember, we followed one specific example (2007 Buick Terraza) for this post; the numbers will be different for different cars, car loans, and leases, but the general concept will be the same.
Feel free to suggest additions/modifications to this write-up. If you like it so far, make sure to bookmark this post so that you can explain the concept to your friend who is all eager to buy gap insurance for a 6 year old Toyota Avalon.