How does gap insurance work?

The moment your new car leaves the dealership and hits the street, its value drops anywhere from 10 percent to 20 percent. If your vehicle is totaled in an accident or stolen, gap insurance covers the "gap" between what you still owe on your lease or auto loan and the amount the insurance company is willing to pay for the vehicle.

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For example, say you buy a new car for $28,000 and the value depreciates by 15 percent when you drive it off the lot. If you were to get into a car accident a few days later – one bad enough to cause your vehicle to be totaled – your insurance company would pay $23,800. That amount represents the car's actual cash value, or value after depreciation.

However, you would still be responsible to pay what is owed on your auto loan. That leaves a gap of $4,200. With gap insurance in place, the difference between the amount owed on the loan and the actual cash value is covered.

Do you need gap insurance?

Depreciation in the first year of vehicle ownership is high but decreases over time. In the fourth or fifth year of ownership, the gap between what you owe and the actual cash value of your car should be smaller, particularly if you've purchased a car that holds its value. Once the actual cash value exceeds the amount owed on the auto loan, you should drop gap insurance coverage. Until then gap insurance, which is relatively inexpensive, can offer financial protection if something happens to your new car.

Buying gap insurance

Gap insurance generally is only available for new vehicles, although some companies allow you to purchase it on a car of any age. If your insurer offers it, it's typically more cost effective to add gap coverage to your auto policy, rather than purchasing it from a dealership or lease agent. Generally, you can only purchase gap coverage if your vehicle has both comprehensive and collision coverage.

Finally, make sure you read the fine print so that you don't duplicate coverage or find yourself caught short when it comes to time to file a claim. If you leased a vehicle, gap coverage may already be included in the lease agreement. If you purchase gap insurance on a financed car, review the details of the gap coverage your insurer offers. Some car insurance companies cap or limit coverage to a specific dollar amount or percentage of the actual cash value.

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