Let's say you took out a five-year loan last year to buy a new car. Naturally, you insured your car at around the same time. If your car is stolen tomorrow and not recovered, or is damaged beyond repair, the amount your insurance company pays may be insufficient to pay off your auto loan. You'll be left holding the bag. Cash may be especially tight if you must buy another car to replace the one stolen or damaged. For these reasons, you should consider buying guaranteed auto protection (GAP) insurance when you buy or lease a new car.
If your car is totaled, your auto insurance will pay only the car's actual cash value
If your car is involved in a serious accident, your insurance company has the option of either totaling your vehicle (i.e., declaring it a total loss) or repairing it. Your insurer will total your car if so much damage has been caused that fixing it would cost more than what the car's actually worth, or, in some states, if required because the safety of the vehicle has been irreparably compromised. Minor damage to a 12-year-old economy car might result in totaling it, while substantial damage to a new luxury car might not.
If your insurer totals your car, it'll pay you or the lienholder (e.g., the bank financing your auto loan) the actual cash value of the car, minus any deductible on your coverage. Basically, the insurance company uses the depreciated market value of the car just before it was totaled. This figure may be substantially less than what you still owe on your loan or lease. During the first two or three years you own your car, your vehicle typically depreciates in value much faster than your loan balance declines, especially if you made a very small down payment on your car.
GAP insurance can pay the balance of your auto loan or lease
GAP insurance pays the difference (the gap) between what you owe on your lease or auto loan and what your insurance covers when your vehicle is stolen or damaged beyond repair. You won't have to worry about dipping into your own pocket to come up with the cash. And, you'll be able to start fresh with a new lease or auto loan. Most GAP programs also cover all or part of your deductible. However, there may be a cap on the amount the program will pay out, such as $50,000.
GAP insurance is not for everyone, so do your homework first
GAP coverage may be important in the early years of your lease or loan. However, once the outstanding balance on your lease or loan drops below the value of your car, you'll no longer need GAP coverage and may want to cancel your GAP policy.
The cost of GAP coverage will vary from one insurer to the next; it will also depend on the type and value of your car. Shop around to get the best deal you can. And remember, GAP coverage is not a substitute for auto insurance. It should be used only to supplement your auto insurance coverage.