If you’ve shopped for a car lately, you know prices are sky-high. In the past 12 months, prices for new vehicles have risen by 12.4%, according to the U.S. Bureau of Labor Statistics, and used cars and trucks are up a whopping 41.2%.
A hefty auto loan or lease can help cover the high costs, but it may leave you “underwater” — owing more than the car is worth — if the vehicle is totaled or stolen. While collision and comprehensive insurance will pay for damage or theft of your car, both coverage types only pay up to the current market value of your car minus your deductible, and you’re on the hook for the remainder. In some cases, this can be thousands of dollars.
Your car dealer may suggest gap insurance, which pays this difference so you don’t have to. In today’s turbulent auto market, gap insurance can be a smart move. But prices vary widely for this extra coverage, so be sure to compare car insurance rates before you buy.
Higher car prices could mean a bigger gap
The “gap” in gap insurance stands for guaranteed asset protection. It covers the difference between your vehicle’s market value and the amount you owe on your car loan or lease. Because cars can depreciate quickly, you may owe more than your car’s value, especially during the first few years of repayment.
Trends in the current auto marketplace can make that gap unusually large, says Caleb Cook, vice president of consumer lending at Massachusetts-based Digital Federal Credit Union. These include:
- Shortages. A pandemic-driven shortage of microchips means car manufacturers can’t meet the demand for new vehicles. With fewer new cars available, sellers can charge higher prices for any vehicle a buyer is able to get, whether new or used.
- Surcharges. Some new-car buyers end up paying a surcharge, “anywhere from $5,000, $10,000, or even more for luxury cars,” above the manufacturer’s suggested retail price, or MSRP, says Brian Sullivan, an independent insurance broker at Avail Insurance Solutions in Oakland, California.
- Lengthy loans. To make high-priced cars more affordable, lenders are extending their finance terms, with seven-year car loans no longer unusual, Cook says. This means smaller monthly payments, but the loan balance stays higher for longer, while the car depreciates in value.
These factors add up to a greater chance of being “upside down” on a car loan or lease, owing more than a car’s value, according to Cook. “People are taking out longer-term financing, taking out bigger loan amounts, paying a little bit over MSRP or paying a premium for a used car,” he says. “Their potential for being upside down is much more.”
Shoppers may not worry about vehicles losing value while used-car prices are high, but this effect is probably temporary. When the auto market eventually corrects itself, those who paid high car prices will be particularly at risk, Sullivan says. Values could plunge, widening the gap between what a car is worth and what is owed on it.
Is gap insurance worth it?
“Anyone who buys or leases a new car or truck should consider gap insurance because the vehicle starts to depreciate in value the moment it leaves the car lot. In fact, most cars lose 20 percent of their value within a year,” said Loretta Worters, vice president of media relations with the Insurance Information Institute, via email.
You may especially want to consider gap insurance, Worters said, if:
- You financed for 60 months or longer.
- You made a down payment of 20% or less.
- You purchased a vehicle that depreciates quickly.
- You leased the vehicle. In fact, some leasing agreements may require gap insurance.
If you don’t have a car loan or lease, or if you made a large down payment, you don’t need gap insurance.
What to know when purchasing gap insurance
You can buy gap insurance through your insurer, your lender or the car dealership, but Sullivan says it’s probably cheapest to go through your insurer. “The premium can be very inexpensive. Typically, you could start out at $19 a year for gap coverage,” Sullivan says.
To compare, purchasing gap insurance through a dealer or lender can cost $500 to $700 as a one-time fee.
Typically, you only need gap insurance for two or three years as you pay down your car loan. Once the loan balance matches the actual value of your car, you should drop gap insurance from your policy.
If you didn’t buy gap insurance when you initially got your car, you may be able to add it later. Some insurers will sell gap insurance for vehicles that are no more than two or three model years old.
In Cook’s opinion, gap insurance is worth considering.
“This current environment’s not going to last forever. We’re going to figure out the shortage,” he says. “So I think in the short run, gap’s probably more important now than it ever has been.”
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Ciarra Jones writes for NerdWallet. Email: [email protected]
The article Why Rising Car Prices Make Gap Insurance Worth a Look originally appeared on NerdWallet.