The same loose lending standards that have landed scores of homeowners “upside down” on their mortgages have had a similar effect on car loans.
You’re considered “upside down” when the outstanding lien (loan) tied to the vehicle exceeds its current value.
Of course, this isn’t necessarily a problem unless you decide to sell your car, or if you’re involved in an accident that totals your vehicle.
In the worst case scenario, you’ll have to pay the difference between what you owe and the value of the car, as determined by the financing company.
Unfortunately, this means you could be making payments on a car you no longer own. Enter “gap insurance.”
Types of Gap Insurance
Gap insurance, or gap coverage, is not actually a form of insurance in most states.
Rather, it’s a debt cancellation agreement between you and your lender.
Essentially, it voids the section of the loan agreement which holds you responsible for repaying the difference between what your car is worth and what is owed if your car is stolen or totaled.
It serves the purpose of relieving you of additional debt on a car you no longer own.
However, some insurance companies may offer you gap insurance in the form of extended coverage for the value of your car.
For example, a company may give you 25% above the appraised value of your vehicle if it’s totaled and gap insurance is in-force.
That 25% could be enough to cover any existing liens/loans and keep you out of a negative equity position.
Gap Insurance Is Key on a New Car Loan or Lease
Let’s look at some specific reasons why you may be “upside down” on your car loan.
Low or “no down” payment options exercised for the purchase of a new or used car are a common reason why gap coverage may be necessary.
Sometimes these offers are referred to as “Sign and Drive” or “Sign Then Drive.”
You lose a great deal of value when the car is driven off the lot, as it’s instantly considered used, and thus worth less than it was moments earlier when you signed the paperwork.
So if you choose to purchase a car with little or no down, your risk of being “upside down” increases because you have little or no equity (ownership) in the vehicle.
Another lending practice that leads to a greater need for gap coverage is the extended amortization (length of time) period available on car loans these days.
Your need for gap coverage will be dependent on the type of vehicle you purchase and the length of the loan.
For vehicles that don’t hold their value well, a six or seven year loan may put you in a position where you owe more on the loan than the car is worth.
Finally, gap insurance can be beneficial when trading up for a new vehicle if your current car loan has yet to be paid off.
In this situation, the dealership provides a new auto loan, which incorporates the remaining debt from the old vehicle.
As a result, you immediately owe more money than your car is worth, which puts you in a position where gap insurance coverage would make a lot of sense (not to mention the value you lose by driving your new car off the lot)!
Gap Insurance Can Be Purchased from Multiple Sources
Gap insurance can be purchased in a number of different ways.
Some insurers offer it as part of your personal auto policy’s physical damage coverage.
Some form of gap coverage may also be purchased, or included, in your loan agreement with your lender, bank, or credit union for an additional fee.
Additionally, there are various online providers who offer gap coverage.
The best place to start is by calling your insurer or independent insurance agent to determine if they have a program that includes the coverage.
Even if they can’t provide it for you, they may be able to point you in the direction of a well established company that provides quality service at a competitive rate.
Gap Insurance Cost
Gap insurance is actually a very cheap add-on to your standard automobile insurance policy.
For around $10 per policy period (6 months), you can get peace of mind with gap insurance coverage.
Assuming your overall insurance premium is several hundred dollars, it doesn’t hurt to pay for gap insurance for the first few years to protect your investment.
Just keep in mind that there are a variety of different types of gap insurance coverage with various coverage amounts, so be sure to ask about all the details before moving forward.
Gap insurance at one insurance company may differ greatly from coverage offered at another.
(photo: Marco Verch)