If you’ve ever bought a new car, you know the car’s value drops as soon as you leave the dealership.
That’s especially true if you’re in an accident. The value the insurance company gives your totaled car may be less than the cost to buy the same make and model again — even if your car was only a few weeks old.
That leaves you to cover the difference, unless you’ve invested in gap coverage. Here’s how gap insurance works, and how it could save you thousands.
My new car nightmare
In 2012, I bought my first-ever new car in cash. It was a basic, entry-level sedan, but to me it was better than an Aston Martin.
But just three weeks after I bought it — with only 600 miles on the odometer — a driver ran a red light, plowed into my little car, and totaled it. I, mercifully, walked away unscathed; the new sedan did its job and protected me.
The driver admitted his fault and had good insurance, so I thought everything would be covered and I would get a new, similar car.
However, I soon found out that my car depreciated a great deal during those three weeks, and the insurance payout was $2,000 less than my car cost. Without gap car insurance, I was out of luck.
I had to pay out of my own pocket to replace my vehicle, even though the driver was completely at fault. It was a tough lesson to learn.
Car values depreciate fast
According to Edmunds, your car drops in value by nearly 10 percent the minute you leave the lot. After just one year, your car’s value can decrease by $5,000 or more.
While depreciation can be a big problem if you bought the car outright like I did, it can be even more complicated if you financed your purchase. According to Jared Staver, a car accident lawyer, lots of people are driving cars that are worth less than they cost to replace.
“Many people are driving vehicles that are worth less than what they owe. The value of a car can depreciate quickly. Additionally, it can take a significant amount of time before you pay enough on a car loan to have equity in your vehicle,” says Staver.
What you owe on your car versus what it’s actually worth can become a major issue if you’re in an accident and the insurance company declares your car a total loss.
For example, let’s say you financed your new car with no money down, and it cost $30,000. A month after you bought it, you’re in an accident and it’s a total loss. You still owe over $29,000 for the car, but thanks to a depreciation rate of 10 percent, it’s only worth $27,000.
Even if you have a comprehensive collision policy, you’re responsible for that $2,000 difference and the cost of your deductible. That means you can end up paying thousands out of pocket.
“Traditional collision insurance will only pay the market value for your totaled car — even if you’re not at fault and someone else’s insurance policy is paying for your totaled vehicle,” says Staver.
What is gap coverage?
“Without gap insurance, you may end up still on the hook for any loan balance beyond the market value of your car, which can put you in a difficult position when you need to replace your car after the accident,” says Staver.
When you rely on your car for transportation to work, you may have to come up with thousands of dollars on short notice to get a new car.
“You may find that you still owe thousands of dollars on your totaled vehicle and don’t have cash leftover from the insurance payout to put toward a new vehicle,” says Staver.
Gap coverage is protection you can add to your car insurance policy when you buy a car. With gap insurance, the insurance company covers the price difference instead of you.
In most cases, you won’t need gap insurance if pay for your car outright; my situation was an extreme example. Gap coverage is most useful for people who finance their cars, since you may owe far more than the car is worth. That way, if your car is in an accident, you won’t be on the hook.
How much does gap insurance cost?
Many dealerships offer gap coverage policies, but they can be more expensive than coverage purchased through your own auto insurer. While dealerships may charge $500 to $1,000, you can likely get gap insurance from your car insurer for a few extra dollars a month.
Keep an eye on your vehicle’s value. Once the amount you owe on your car loan is less than your car’s value, you can safely cancel your gap coverage.
Is gap insurance worth it?
While gap coverage is not necessary for everyone, consider adding a gap insurance cost to your policy if you’re buying or leasing a new car. Doing so can help save you thousands in case of theft or an accident.
For more information on auto insurance, see how a good credit score can help you save money on a new car insurance policy.
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