What is gap insurance on an auto loan?

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Here's what you need to know...
  • When you finance a vehicle, your loan payments will go towards interest and the principal of the loan (the balance of the amount financed)
  • If you buy a new car, the vehicle will depreciate by as much as 10 percent after you drive it off of the lot. It will depreciate another 10 percent by the end of year 1
  • Since vehicles depreciate quickly, it’s important to build an insurance portfolio that protects you when you have a total loss
  • Under your standard auto insurance policy, your insurance is only required to pay for the vehicle’s replacement cost minus depreciation. In the industry, this is called a private passenger’s Actual Cash Value
  • If you don’t want to be stuck paying for the depreciation after a total loss, you should consider buying GAP insurance. GAP will pay the difference between your total loss payment gap and your loan balance after a covered loss

A majority of car buyers will finance their purchase. Since a car purchase is one of the bigger purchases that you’ll make in your life, aside from buying a home, it’s important that you understand how your loan works.

Not only should you compare interest rates and dealership promotions, you should also take time out to learn about your responsibilities as a borrower.

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Whenever you take out a loan, it’s your duty as a borrower to keep up your payments. Payments will consist of an interest charge and principal.

One of your requirements, when you finance a car, is to carry full coverage auto insurance. It’s required so that the collateral on the loan is protected.

Unfortunately, your insurance might not pay what you expect it to. This is when GAP insurance can come to the rescue.

Is full coverage enough when you’re financing a car?

It’s hard to believe that full coverage insurance could leave you at risk when you have a loss.

What many people don’t understand is how much their policy will pay when they have a total loss.

Sure, comprehensive and collision insurance will pay for physical damage to your vehicle, but that doesn’t mean that it will pay as much as you need it to.

You’re obligated under your finance agreement to purchase full coverage insurance and maintain it for as long as the agreement is valid.

Just because you’re only required to buy full coverage doesn’t mean that you don’t have to worry about a loss. When you owe more on the car than it’s worth, you could get stuck paying thousands for a car you can’t drive.

How much will your auto insurance pay when you have a loss?

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It’s important to understand how every aspect of your insurance contract works before you ever need to use it.

By knowing how your policy pays and what your responsibilities are as a policyholder, you can equip yourself with all of the optional forms of coverage that you need.

Under your policy agreement, it says that your policy will only pay for repair or replacement of your vehicle when you carry physical damage coverage and you have a covered loss.

Unfortunately, when you have a loss, there’s a limit to how much the insurer will pay. This limit is referred to as the car’s Actual Cash Value.

What is Actual Cash Value?

Actual Cash Value (ACV) is an industry term that’s used all over your declarations page and your personal auto policy contract to define how much the insurer will pay.

If you were to look up the definition of Actual Cash Value, you would find that it means the replacement cost of the property minus depreciation. Oftentimes, ACV and fair market value are used interchangeably.

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How quickly do vehicles depreciate?

Since depreciation can bring down your total loss settlement, it’s important to research how quickly cars lose their value so that you can decide if you need an extra layer of protection when you’re financing.

The rate of depreciation depends on several factors: the vehicle make, the demand for the model, the condition, and the mileage.

The biggest factor that will affect how much depreciation will affect you when you’re taking a loan out on a vehicle is if the car was new or used when you bought it.

When you buy a new car, it depreciates by about 10 percent of its value right away. After that, the car steadily loses value each year as follows:

  • At end of year 1, the car is worth 81 percent of its original value
  • At end of year 2, the car is worth 69 percent of its original value
  • At end of year 3, the car is worth 58 percent of its original value
  • At end of year 4, the car is worth 50 percent of its original value

How can you protect yourself when your car depreciates?

The standard auto policy won’t pay for the depreciation charge. This means that there is a good chance that you will have to pay for the depreciation after the loss has been settled.

If you don’t want to be stuck paying for 10, 20 or 30 percent of the car’s value after a total loss, you should consider buying GAP insurance.

What is GAP insurance?

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Most finance companies don’t require you to buy GAP insurance.

While it’s not a requirement, it’s definitely an optional form of coverage that you should carry if there’s a good chance that you will owe more than the car is worth.

By having this form of protection, you can rest assured that your loan will be paid off regardless of how much you owe.

Where can you buy GAP insurance?

You can either finance the cost for GAP insurance with your lender when you’re in the finance department at the dealership or you can buy GAP through your insurer.

If you elect to carry GAP on your auto insurance policy, it will cost about 5 to 6 percent of the full coverage premiums every term. You can remove it when you’ve paid your loan down.

If you have rolled over negative equity in your loan or you didn’t make a large down payment, it’s wise to pay for extra GAP coverage.

It’s affordable coverage that can save the day during a tough time. To find out how much GAP costs through large insurance carriers, use an online rate comparison tool and start comparing rates today.

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