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The dramatic plummet of your new car's value as soon as you drive it off the dealer's lot can put significant strain on your finances if your car is totaled. That's why when insuring a new car, you need to know the role gap insurance plays in protecting your investment.

If you're entitled to an insurance payout for a totaled car, your car insurance company pays you the actual cash value (ACV) of the vehicle. And the amount your insurance company calculates as your car's actual cash value can be thousands of dollars lower than what you still owe on your car lease or loan, especially within the car's first few years of ownership. Since you're responsible for paying the remainder of your lease or loan even when your car is totaled, you have to come up with the difference. Unless you have gap insurance.

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What is gap insurance?

Gap insurance pays the difference between the amount a car insurance company pays for your totaled car and the amount you owe on your lease or loan. Without gap insurance if you're upside-down on your car loan you'll be personally responsible for this amount.

Within the first year, a new car loses between 11 to 20 percent of its value, according to the National Automobile Dealers Association. For a car that costs roughly $30,000, that's between $3,300 and $6,000 in the first year. However, certain vehicles retain their value better than others. For example, when gas prices skyrocket, resale prices for fuel-efficient cars increase.

Any money that you owe over what your vehicle is worth after a total loss, is yours to pay. Car insurance companies only pay up to the value of your vehicle, they do not care how much you may owe on the vehicle.  So if you owe more, gap insurance is your only way to cover this "gap."

For example:

You buy a new car worth $30,000 and you put down $2,000 pay other taxes and fees. Your loan is for $28,000. A few months later you total your vehicle in an accident. Your insurance company finds that your vehicle is only worth $25,500. You are going to have to pay a $500 deductible and end up with only $25,000, leaving you $3,000 still owing on your loan. With gap insurance this amount would be covered and not have to come out of your bank account.

Similar to gap insurance is lease/loan coverage. Lease/loan coverage covers the gap between what you owe on your car and its actual cash value. However, the difference is lease/loan coverage only provides a payout up to a certain percentage of your vehicle's value, typically around 25 percent. If your $30,000 vehicle has depreciated to $25,000 then loan/lease coverage covering up to 25 percent would pay up to $6,250.

In addition to depreciation, many drivers are paying more for cars and financing them for longer terms than they were five years ago, according to Edmunds.com. The average price for a new car stands is $34,623, compared with $31,078 five years ago. And, the average loan term is now 69.5 months, nearly six years, compared with 65.7 months. 

Wrong assumptions about total losses

Many drivers wrongly assume that if their car is declared a total loss in an accident they're going to recover the amount they owe on the car or, if it's new enough, the amount they paid for the car. But cars don't hold their value like that.

When you drive the car off the lot, you've automatically lost the fees you paid for things like licensing, destination charges, advertising and documentation. Those are one-time costs that you won't get back if the car is totaled, but they are incorporated into the total price of your new car at purchase. However, you may be entitled to make a claim for reimbursement of sales tax when you purchase a replacement car.

With a car loan or a lease, you usually haven't paid for that much of the car in the first year, so this is the time when the difference between what you owe and what the car is worth could be the greatest. Over the next two to three years, the car's depreciation begins to slow. It then levels off, and by the fourth or fifth year of ownership, you can consider dropping gap coverage, since the value of the car and what you owe have usually aligned.

It is also worth remembering when you buy a new car that the most popular new cars are also the most popular used cars, meaning they hold their values better.

Lease/loan payoff coverage

Not all insurance companies offer gap insurance, but many if they don't have gap will have lease/loan payoff coverage. While very similar to gap insurance, lease/loan payoff coverage only pages up to a certain percentage of the ACV of the totaled vehicle. For example, Esurance and Progressive each say they will pay up to 25% of the ACV of your vehicle.

For example: Let's say your car is declared a total loss after a covered incident and you receive $25,000 as the value of your vehicle (ACV) from your collision claim, however, you owe $30,000 on the loan still. Loan/lease payoff will pay the $5,000 gap. If your loan amount was $32,000 though, the most the lease/loan payoff would pay is $6,250 (not the full $7,000 as it exceeds 25% of the ACV).

Tips on how to buy gap insurance

Many car lease contracts include gap insurance but require you be in total compliance with the lease in order for the gap coverage to pay out. Most gap insurance policies offered through a lease contract require you to continue to make monthly payments until the gap payment is received.

If you decide to finance your vehicle through a bank, you probably won't have a contract that provides you with automatic gap insurance. Many car insurance companies sell gap insurance but don't advertise the fact. And some of the biggies don't sell it, or loan/lease payoff at all. For example, GEICO doesn't sell it.

Auto-Owners Insurance Co. is among those that do. But like many insurance companies, Auto-Owners offers gap coverage only to those who have bought brand-new, never-before-titled cars and who also have purchased comprehensive and collision insurance (if leased for 12 months or longer). Auto-Owners recommends that coverage be purchased when he or she initially purchases insurance, as this is when the gap is the largest.

Other car insurance companies will allow you to purchase gap coverage up to 11 months after you purchase your car, or if the car is in the model year in which the insurance is purchased. Check to see if the car insurance company has a cap, either in a dollar amount or in percentage, for total gap payout, especially if you are getting the lease/loan payoff coverage. Insure.com found that gap insurance costs $41, on average, per year, hiking rates by a mere three percent, based on analysis of rates from up to six major carriers for 10 ZIP codes in each state.

Gap coverage can only be purchased on a vehicle that has both collision and comprehensive coverage and a loss payee or lienholder at Progressive.

Other companies that currently sell gap insurance or loan/lease payoff coverage are American Family, Erie Insurance, Esurance, MetLife and Safeco. However, most car insurance companies that offer gap coverage do not offer standalone gap coverage but as an "extra" on an existing policy.