Gap insurance: What is it and do you need it?

If you’ve ever bought a new car, you’ve probably had a salesperson talk to you about gap insurance.

It’s an insurance product designed to cover the gap between the outstanding balance on your auto loan and the market value of your vehicle if your vehicle gets totaled in an accident or stolen before you’ve paid it off completely.

Let’s take a closer look to give you a clearer picture of how gap coverage functions and if it’s right for your situation…

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Understanding gap insurance

Let’s say you finance a new vehicle for $34,000. Then, a week after driving off the lot, that car is declared a total loss in a serious accident.

Fortunately, you escape the accident unharmed and expect your insurance company to pay out $34,000 so you can pay off your loan and get into a new vehicle.

Here’s the catch, though: The minute you drove that vehicle off the dealer lot, the value of it depreciated to $31,000.

Now your new car is totaled, you can’t drive it and you still owe the $34,000 loan. Your insurer, however, only wants to pay you $31,000 because that’s the market value of your totaled car.

This is the kind of case where gap insurance would step in with the $3,000 difference so it doesn’t have to come out of your pocket.

But that’s just a hypothetical situation. Let’s take a look at how it plays out in the real world.

How gap insurance would work in a real-life situation

One member of our Consumer Action Center reports that her son was recently involved in an accident while driving a newly leased vehicle.

“I had a lease on a Genesis and never thought of gap insurance for a lease. The car was totaled and the difference between the buyout and the value is $2,962,” our volunteers tells us. “Therefore, I have to pay the difference between the value and the buyout.”

Gap insurance would have paid this difference if she had a policy.

And get this: The accident was not the fault of the volunteer’s son, yet she still has to pay that gap out of her own pocket because she didn’t have gap insurance.

The Insurance Information Institute reports adding gap insurance to your collision and comprehensive coverage usually adds only about $20 a year to the annual premium.

That’s a potentially small price to pay for peace of mind.

Where should you consider buying gap insurance?

As a general rule, car dealerships are the worst place to get gap insurance because they tend to inflate the premium and roll it into the cost of your loan.

Try these alternatives instead.

Buy gap coverage through your auto insurer

By doing this, you're likely to pay half or even a quarter of the price you would pay at the dealership, according to Car and Driver. That's because your insurer won't ridiculously mark it up like the dealer will.

Pay cash for a reliable used car

Gap insurance is a solution to a problem that shouldn’t happen in the first place. When you think about it, there would be no need for gap coverage if consumers didn’t buy vehicles with no money down.

The problem, as mentioned earlier, is the rapid depreciation of new vehicles the minute they drive off the lot. Since you put no money down, that huge spread is what creates a gap that need to be filled.

But what if your buying decision never allowed that gap to be created in the first place?

Buying a reliable used car is money expert Clark Howard’s preferred way for you to get into a vehicle. It’s possible to pay cash for a cheap but good ride.

Here's a look at the 19 best used cars under $15,000.

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