Other than a home, a new car may be the biggest purchase you’ll ever make; and other than your house payment or rent, your car loan is likely to be your largest monthly expense. That said, when it comes to serious damage or loss, standard auto insurance policies sometimes do not provide all the financial protection you need for your investment.

When vehicles are stolen or totaled in accidents or natural disasters, many people find out too late that their insurance settlements are less than the amounts they still owe on their loans. It’s not unusual today to be “upside down” on a car loan — that is, to have a car that’s worth less than the amount owed on the loan. In fact, that scenario is so common there’s a special type of insurance, called gap coverage, designed to protect against it.

Walk away from a financial nightmare

Totaling a car is bad enough, but having to continue making loan payments on a car you can no longer drive turns an unfortunate situation into a financial nightmare. It’s easy to find yourself in a financial crisis when a car is totaled or stolen.

For example, if your car is totaled when you owe $30,000 on it, but the book value at the time of the loss is only $20,000 and your insurance deductible is $500, typically your insurance payout will be only $19,500, leaving you with a gap of $10,500. Gap protection covers that $10,000 difference in value, and in some states it even covers the $500 deductible. When you’re upside down on a vehicle loan, gap protection makes it possible to walk away from the loss and start over.

Available as insurance or a contractual waiver

Although it is commonly called “gap coverage” or “gap insurance,” in most states gap protection is actually a debt-cancellation agreement, not insurance. Generally, gap protection is a contractual provision in your automobile financing agreement. In most states, when you obtain your vehicle loan and elect gap coverage, your contract includes a waiver relieving you of responsibility for the difference between your outstanding loan balance and the value of the vehicle. But regardless of whether your gap protection is, technically speaking, insurance coverage or a contractual waiver, the effect is a release of liability beyond the value of your totaled or stolen car.

The obvious case for gap protection

Not everyone needs gap coverage. But more and more — as car dealers offer financing terms of 72 months or longer, little or no money down, and rollover of unpaid loan balances into new financing agreements — at some time during the term of a loan, the vehicle will be worth significantly less than the outstanding loan balance. If you buy a car on those kinds of terms – especially a new car which depreciates drastically the minute you drive it off the dealer’s lot — gap coverage is generally a wise choice.

A wise choice in less obvious cases, too

Gap coverage may make sense in less obvious circumstances as well. In many cases, even with a decent down payment and a shorter loan term, a new car will depreciate much more rapidly than the loan will be paid off. Not surprisingly, many lenders and leasing companies now automatically include gap coverage in their financing and lease agreements.

How to calculate your risk of a gap

To figure out whether you’re risking a gap in coverage, you’ll need to know something about the future depreciation of your vehicle and the amortization of your loan. Future vehicle depreciation is nothing more than an educated guess, but to estimate your potential for a gap, try using a depreciation calculator like the one at Money-zine.com. You can also get a rough idea of the future depreciation of your vehicle by looking at the past depreciation of the same model in the Kelley Blue Book.

Then refer to your loan amortization schedule, if you have one, or use an online loan calculator like the one at Bankrate.com to see the rate at which your loan balance will be reduced over the term of your loan. For some period of time during the loan term, the value of your depreciating vehicle is likely to be less than your loan balance.

Where to get gap protection

Most people purchase gap coverage through their lenders when they purchase their vehicles. But if you’ve already purchased a car and now find that you have a significant gap in your insurance coverage, you may be able to purchase gap protection from your current lender or credit union, your auto insurance carrier, or an online seller. Be aware that if you buy gap coverage from your insurance carrier, there will be an extra charge on your premium statements and it will be up to you to remember to have the coverage removed when you no longer need it.

Not all gap coverages are the same

If you have several gap-coverage alternatives, compare the various protections offered before you decide to go with the lowest price. The most basic gap protection simply covers the difference between your insurance payout and your unpaid loan balance. Other forms of gap protection include the amount of your insurance deductible, and even a set amount to be applied toward the purchase of a new car.

Better yet, some coverages calculate the gap based on vehicle replacement cost rather than the value of the totaled vehicle. Be aware that some forms of gap protection cover vehicles totaled in accidents, but not those lost to theft or natural disaster, while others cover all forms of total loss.

Upside down is the order of the day

Because of low used-car values, minimal down-payment requirements, extremely long-term loans, and loan rollovers, it’s not uncommon today for car buyers to start out upside down on a loan to the tune of many thousands of dollars. So gap coverage is important. If you’re thinking about buying a car, keep in mind that owing more than your car is worth may indicate that you really can’t afford the car in the first place. When possible, avoid digging yourself into unmanageable debt by taking these steps:

• Drive your current car a little longer while you save up at least a 20% down payment.
• Purchase a less expensive car.
• Opt for a used vehicle to avoid those first few years of rapid new-car depreciation.
• Sell your used car yourself in order to get the highest price for it.
• Avoid frequent trade-ups which typically involve rolling the balance of an old loan into a new one, leaving you instantly upside down on the new loan.

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