What is gap insurance?

You're at the dealership, going through all of the paperwork and financing before you finally get your keys. There are a lot of unfamiliar terms being tossed around when they ask if you want gap insurance. More often than not, shoppers will ask what gap insurance is and get an answer that will typically encourage them to add it, not knowing fully what it is. If you're among the majority that aren't sure, here's all the information you need to make an informed decision.

Gap insurance covers the difference between what a vehicle is worth, versus how much is owed on it. For instance, if you financed a car for $30,000 with a $3,000 down payment, that means you owe $27,000 on the vehicle. Now let's say you suffered an unfortunate accident that totaled the car and your insurance will only pay $22,000 because the vehicle begins to depreciate as soon as you drive it from the dealer. That means you're responsible for the $5,000 difference. 

Gap insurance covers that difference so you won't have to pay it out-of-pocket. Oddly enough, the name doesn't refer to the disparity between the vehicle's worth and what is owed, it's an acronym of "guaranteed asset protection." The scenario above is a prime example where gap insurance comes in handy and could be considered if you make a small down payment (less than 20 percent), if you have a long finance term of 60 months or longer and if your particular vehicle tends to depreciate quicker than average. Gap insurance is often required for leases, and it's a good idea to have it if you log a lot of miles per year.

For many shoppers, gap insurance is a sensible addition and shouldn't be thought of as a dealer ploy to separate you from your money. Well, not entirely. Now that you know what it is, it's important to know how much it costs. At the dealership, they may have a flat rate between $200 to $500. In our heads, it sounds like a decent deal to spend a few hundred to avoid spending several thousand later, and you wouldn't be wrong.

The problem is, your insurer likely offers gap insurance for much less. It's an add-on to your basic policy and prices range from $20 to $60 extra per year. Unlike the up-front rate, you can cancel gap coverage once the vehicle's worth is equal to the remaining balance financed. It's also worth noting that if you added gap insurance at the dealership, you might be paying interest on it for the term of the loan.

The takeaway on gap insurance is pretty simple. It's a useful way to reduce your financial liability if you owe more than the vehicle is worth, but you should check with your insurance provider to see how much it costs versus what's being offered at the dealership.