Consider Gap Insurance if you’re under water by any significant amount

Insurance companies typically only insure for the “actual cash value” of the vehicle at the time that a claim is made. So if you’re in an accident and the car is “totaled” then the insurance company will only give you a check for the amount you could have sold the car at the time on the open market (less the amount of your deductible). It’s for this reason that you may want to consider gap insurance if you’re under water on your auto financing.

To understand how devastating this can be consider the following example:

  • You buy a new car for $25,000 with zero down and roll $5,000 in negative value from your old car into the loan. That makes the actual “purchase price” of the vehicle $30,000.
  • Though it varies by car make and model, because it’s a new car, when you drive it off the lot it will typically lose around 20% of value. Your new $25,000 car that you bought for $30,000 (because of the negative equity in your old car) is now worth only $20,000.
  • You have an accident and the car is totaled one week after buying the new car at the dealership.
  • Assuming your deductible is $1,000, your insurance company gives you a check for $19,000. But you still owe the balance of the loan, which is $11,000! Clearly this is not a situation anyone wants to be in.

Gap insurance covers you in this situation. Gap insurance was established in the 1980’s to protect consumers from this problem. Gap insurance is additional insurance you can buy to cover the difference between the actual value of a car that has been totaled and the amount owed on the loan.

Gap insurance is a relatively low cost item and can be purchased at the dealership at the time of purchase or purchased after buying a car from an insurance carrier. If you have significant negative equity in a car deal you should seriously look at this option to protect you from a potential big problem in the future should you have an accident that totals your vehicle.

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