Gap insurance is a type of auto insurance that car owners can purchase to protect themselves against losses that can arise when the amount of compensation received from a total loss does not fully cover the amount the insured owes on the vehicle’s financing or lease agreement. This situation arises when the balance owed on a car loan is greater than the book value of the vehicle.

As an example of gap insurance at work, consider John’s car, which is worth $15,000. However, he still owes a total of $20,000 worth of car payments. If John’s car is completely written off as a result of an accident or theft, John’s car insurance policy will reimburse him with $15,000. Because John owes the car financing company $20,000, however, he will still be $5,000 short, even though he no longer has a car.

If John purchases gap insurance, the gap insurance policy would cover the $5,000 “gap,” or the difference between the money received from reimbursement and the amount still owed on the car.

Reasons for Gap Insurance:

• Financing a car and made minimum or no down payment
• Trading in an upside-down car (still owe balance on car)
• Bought a car with bad resale value
• Planning to put miles on quickly
• Taking a car loan for a long term (more than 60 months)