The Financial Reader

GAP (Guaranteed Auto Protection) Insurance is an added insurance for your vehicle. While your regular auto insurance may pay for costs to get your car repaired or replaced in the event it is damaged, your regular auto insurance will not protect you if you are upside down on your car loan (you owe more on the car than what the car is worth) and your car needs replaced. However, if your car is totaled and you have GAP insurance, the GAP insurance will pay the difference of what you still owe the bank on your car and what the value of your car is.

To illustrate….. you financed a car last year. Today, your car is totaled in an accident. You still owe $20,000 on your car, however, the cash value of your car is only $16,000; which is what your collision or comprehensive  auto insurance will reimburse you for your loss. In this case, you still owe your bank $4,000 on a car that you can’t even drive in addition to having to purchase an additional car. If, however,  you have GAP insurance, you will be covered for that $4,000 that you still owe the bank.

While GAP insurance isn’t necessary for everybody, in many cases it is a wise choice. To determine if GAP insurance is worth the cost, you will need to determine the likelihood that you will be upside-down on your car loan. Being upside-down on your car loan is a greater risk towards the beginning of your car loan, but as you get closer to paying off your loan the risk diminishes.

Some warning signs that you may be upside-down on your loan are:

You finance your car for a longer term. You are at greater risk of owing more on your car than it is worth if you have a 5 or 6 year loan than say a 3 year loan, since the longer the loan term is the slower the principal gets paid off.
The interest rate on your loan is high. If you are paying a high interest rate, than you are at a higher risk of being upside-down on your car loan. The reason being that with a higher interest rate, more of your monthly car payment will be applied to interest rather than the principal.
You simply got ripped off. If you over paid for your car, than unless your down payment was sufficient, you owe more on the car than it is worth. Look at the NADA or Kelley Blue Book values of the car you are interested in purchasing. Another good source for car pricing is edmunds.com. Also, look in the auto ads to see what other dealers or private sellers are selling that car for in your area.
You put little to no down payment on the car. A smaller down payment of course means that you financed more of the car’s price. On the other hand, making a large down payment on a car should put you ahead of the game as far as your car’s value versus the amount you financed.
You purchased a brand new car. A brand new car depreciates on average 11% as soon as you drive it off the car lot. In turn, unless your down payment was sufficient, you already owe more on the car than it’s cash value immediately after signing the dotted line. Ouch!
The make or model of your car depreciates more quickly than normal. Do some research on car depreciation histories for the car you are purchasing. Some makes and models have a reputation for quickly losing their value. The age of the car also influences the depreciation rate.

The key to determining if GAP insurance is worth the coast is to determine the likelihood that you will be in a situation where you owe more on a car than it is worth. Reviewing the above points will help you determine if the extra cost is worth it or if it is throwing money down the drain. The cost of GAP insurance is minimal if you are in a situation where you need to replace a car that is totaled but you owe more on the car than it is worth. On the other hand, if it is unlikely that you will be upside down on your auto loan, than GAP insurance is simply a waste of money.

GAP insurance (as well as all insurances or extended warranties) is placing a bet that something will go wrong; so you also have to evaluate your risk, risk aversion, as well as your ability to cover the costs if indeed something does go unfavorably for you. 

One other thing to mention, some lenders will require that you purchase GAP insurance to protect themselves. Most lenders will have a relationship with a GAP insurance provider; so if you are required or you wish to purchase GAP insurance the GAP paper work will be signed with your lender at the same time as your loan closing.