If you’re buying a new car (or new-to-you car), you might be wary when the car dealer asks if you'd like to purchase gap insurance. Is gap insurance just another way to trick you into paying extra for something your auto insurance already covers?

Let’s take a closer look at what gap insurance is, what it covers (and doesn’t), and when purchasing gap insurance can pay off.

What is gap insurance?

Gap insurance, otherwise known as guaranteed asset protection or "gap" for short, is optional coverage usually offered when financing a car loan at a dealership or bank or leasing a car.

Gap insurance coverage is exactly what it sounds like — an insurance policy that covers the gap between what car insurance companies would have to pay for your totaled or stolen vehicle and what you still owe on your auto loan.

As soon as a car pulls out of the dealership’s lot in your possession, it loses some of its market value. It depends on the make, model, and year, but Kelley Blue Book estimates you lose as much as 20% of a new car’s value within the first year.

How does your insurer determine your vehicle’s actual cash value? J.D. Power says it’s a snapshot of the fair market value of your vehicle right before the accident or theft. "It takes into account depreciation, and thus, the actual cash value will be less than what you purchased the car (for), even if it is relatively new."

While you probably have comprehensive and collision coverage on your new ride, you’ll end up underwater in your car loan if the vehicle’s actual cash value is less than what you owe. That’s why when you lease a new set of wheels, the lender might require gap insurance to cover their investment.

What does gap insurance cover?

In order to carry gap insurance, you’ll also need collision and comprehensive coverage for your vehicle through your car insurance provider. When you file a claim, the auto insurance company will pay the actual cash value of your stolen or totaled car. Your gap insurance works by covering the difference and paying off the remaining loan balance or lease.

It’s important to note that gap insurance isn’t meant to cover all the costs that your comprehensive and collision coverage fail to pay out. Gap coverage specifically guards against the risk of negative equity in the event that your new vehicle is totaled or stolen.

There are a few instances when gap insurance might not cover the full car loan balance. Some policies specify an upper limit for what gap insurance pays, so you could owe money if the fair market value of your car has tanked and you have significant negative equity.

What doesn’t gap insurance cover?

Gap insurance isn’t a catch-all solution for all the costs that aren’t covered by your comprehensive and collision policy. Here are a few instances when gap insurance won’t bridge the difference and save your bank account.

• Car insurance deductibles. In the case of a claim, you’re usually required to pay your deductible before insurance coverage kicks in.

• Finance charges. Some upfront fees, including taxes and processing fees, won’t be covered by gap insurance.

• Mileage charges. Many lease agreements charge penalties if you exceed the allowed mileage on your leased vehicle. Those penalties aren’t covered by gap insurance.

• Car repairs or engine failure. If your vehicle needs significant repairs or has engine failure, gap insurance doesn’t cover costs that would usually be handled through the warranty.

• Vehicle damage or accident-related injuries. Your collision coverage should handle vehicle damage from an accident, while personal injury protection pays for injury-related expenses.

• Late fees or overdue payments. Any fees you’ve incurred for late payments won’t be part of the package with gap insurance coverage.

• Security deposits or down payments. Your down payment wasn’t financed, so it’s not part of the loan and therefore not eligible to be reimbursed by gap coverage.

• Extended warranties. If you opted into an extended warranty, the cost won’t be covered by gap insurance.

• Car replacement coverage. It might be obvious, but gap insurance doesn’t cover the cost of replacing your car. Read our guide to learn more about how to get better car replacement coverage.

Some of the costs listed above might be covered by comprehensive or collision coverage, so check with your car insurance company for additional questions about how your specific insurance policy works in conjunction with gap coverage.

How does gap insurance work?

Let’s take a closer look at how a gap insurance claim can work with collision coverage and comprehensive insurance to cover more than a vehicle’s actual cash value.

Let’s say you bought a new set of wheels for $35,000 about a year ago. But you got into an accident, and the vehicle is now a total loss, according to the insurance provider. Because of car depreciation, the vehicle’s actual cash value is $28,000, but you still owe $30,000. Without gap insurance, the insurance company will pay out the $28,000, but you’d still owe the remaining $2,000 to the loan provider.

How does gap insurance help? Gap insurance will ride to the rescue with $2,000, meeting the gap between the car’s actual value and the remaining loan amount. Just keep in mind that you don’t get to pocket the spoils of a gap insurance policy. That money goes straight to the auto loan provider.

5 reasons you might need gap insurance

Although some lease agreements may require gap coverage, gap insurance isn’t mandatory in any state or required by an auto insurer. A car dealership may offer gap insurance or automatically add it to your loan but you can decline the coverage if you’re buying the car.

The following are a few scenarios in which the Insurance Information Institute advises purchasing gap insurance as a safe bet against car depreciation.

1. You put down less than 20% on your new vehicle. Typically, this means most of the cost of the car is rolled into the loan, so you’re at greater risk of negative equity in the first two years of owning your new ride.

2. You’re leasing a new vehicle. Leasing instead of buying a new car? Double-check the fine print because chances are gap coverage is already part of the deal.

3. Your car loan is 60 months or longer. Longer loans mean bigger payoffs over time and more interest, so you’re more likely to be underwater on your vehicle’s equity for a longer period of time.

4. Your new vehicle is known to depreciate quickly. Car depreciation can be significant. One analysis turned up ten high-end car brands with models that have a depreciation rate as high as 90%, including Mercedes and Lexus models.

5. You rolled negative equity from an old car into your new auto loan. No judgment, but if you’re still paying off negative equity from a previous car as part of the package on your new car loan, it’ll cost you. And gap insurance could help protect from another loss so you don’t compound the problem.

There may also be eligibility requirements for gap insurance, such as verifying you’re the original owner of the vehicle and that the car model is a recent one.

Where to buy gap insurance

Often gap insurance is offered at car dealerships when you finance the loan or lease, but rolling the cost into your monthly car loan payments means you’ll be paying interest on the cost of gap insurance.

Instead, consider buying gap insurance from the same auto insurers that provide your comprehensive coverage. Just beware of offers from your auto insurer for replacement coverage. Policies that cover the cost of replacing your car with a new car of the same make and model are not the same as gap coverage and can cost significantly more

You can also check with your bank or credit union to see if they offer gap coverage for customers who finance auto loans with their institution.

How much does gap insurance cost?

On average, car dealerships charge around $60 a month or a flat fee of $500-$700 a year for gap coverage. But remember that if you’re purchasing gap coverage from car dealerships and the cost is rolled into your loan, you’ll also be paying interest on your insurance costs.

Alternatively, buying gap coverage as an add-on to your car insurance policy costs anywhere from $20-$40 a month, significantly less than at a dealership. You should also cancel gap insurance as soon as your loan balance is equal to or lower than your vehicle’s fair market value.

Is gap insurance worth it? Answering that question involves doing the math on your car’s actual cash value, the average depreciation rate, and your car loan amount. But for most new cars, gap insurance can be a smart and relatively cost-effective safety net.