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UPDATED: Mar 13, 2020
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When you finance a vehicle, whether you are leasing or buying, one of the grim realities of car ownership becomes quickly apparent: your car is not worth what you are paying for it, at least for the first few years. This is because of something called depreciation; the value of your car sinks quickly for the first few years, although your payments do not pay off the principal balance until the end of the loan. Therefore, it will generally take a few years for the value of your car and the amount you have financed to balance.
Here is an illustration of this principle. Suppose you go onto a car lot and buy a brand new vehicle worth $28,000. You put down $3,000 in cash or trade and finance $25,000 for five years at three percent interest. At that moment, the car is “worth” $28,000, or exactly what you are paying for it. However, as soon as you drive it off the lot, depreciation begins. At the end of one year, your car is worth $18,000, having lost $10,000 in depreciated value. If you were to sell the car at that point, you could only get $18,000 for it.
However, you have financed $25,000 for five years. Due to the magic of amortization, your first payment of $449.22 applied only $386.72 toward principal; the rest was payment of interest. By your twelfth payment, or one year after you financed your new car, only $397.49 of your payment is being applied to principal. This means that you have a principal balance of $20,295 left to pay in order to own your vehicle. You actually owe the loan company almost $2,500 more than the vehicle is worth; this is referred to as being “upside down” in your vehicle. It will probably be another year or two before what you owe in principal balances with what your car is actually worth.
What happens if, at this point, you have an accident and your vehicle is totaled?
The insurance company will normally pay “book value” on the vehicle; in other words, they will pay $18,000 toward the payoff of the car. Guess where the other $2,500 will come from? Even more disturbing, most financing agents will want the balance immediately since they no longer have an asset to repossess if you fail to make the payments. This is known as “calling the loan due.” You may be forced to borrow money from another source simply to pay off your car loan. If you do not pay the residual balance, the financing company can sue you for it and even garnish your wages to collect the debt.
What is GAP insurance?
If you do not want to be stuck with a huge debt for a car you no longer own, you want to consider gap coverage. Gap policies are special policies you purchase to prevent the foregoing scenario from catching you unawares. A gap policy pays the difference between what your car is worth on the market and what the financed balance of the vehicle is at the time of the accident.
Gap coverage is extremely useful if you are financing a new car. While many people do not think about this until it is too late, the time to consider gap coverage is before you find yourself in the position of owing more than your car is worth.
Of course, there are alternatives to gap coverage. You can pay cash for a vehicle and simply take the loss if you have an accident which totals your car. You can save the gap amount yourself and pay the car off if it is totaled. However, gap coverage tends to be very reasonable in price, and it is usually a good investment to protect you from a heavy debt load.
How do I buy GAP car insurance?
You can find gap insurance in two ways. Most car dealerships offer it as a built-in part of your payment price. In this instance, you purchase a policy up front and finance the premiums over the life of the car loan. When you pay off your loan, gap coverage ceases. The disadvantage to this method is that you are paying for the coverage up front, and cannot cancel it once your car value and your loan value are the same.
You can also purchase gap coverage from your car insurance agent. These policies may be cheaper, and you have the advantage of cancelling the gap coverage once the principal balance on your loan and the value of your car have equalized. If you pay off the car early, you no longer have to carry gap coverage.