Gap insurance is basically the difference between the worth of the car and the amount you owe on the car. This comes into play when the car is totaled or stolen when the car owner is still making the payments. A car is totaled when it is damaged to an extent that the repairs would exceed the worth of the car.
We can illustrate this with an example. Let us assume that you purchase a car for 20,000 and you make a down payment of $500 and you are expected to pay $350 per month.
If the car is involved in an accident just barely six months after purchase and if it is totaled, then the collision insurance company will determine that your car which is six months old is presently only worth $16,500. This amount would be paid by the insurer to you after subtracting the collision deductible in case the accident is your fault. Hence, if you have already made 6 monthly payments along with the down payment, then on a total of $2,600 you will still have to pay $17,000 on your car. Under such circumstances, gap insurance will pay the difference of $1,100 between what is covered by the collision insurance ($16,500) and the amount you owe on the car ($17,400). Hence, if you had not purchased gap insurance, you would have had to shell out the extra amount of $1,100 from your pocket. (It is important to note that if the insurance company arrives at the conclusion that your deductible is applicable, then you will have to shell out that money and that will not be covered by gap insurance).
If you are a buyer, gap insurance will only make sense if you owe more than what the car is worth. For instance, if the down payment is low, or if you have purchased a vehicle which depreciates quickly, have high rate of interest, or if there are other costs like money owed on a trade-in on your new car payments, then gap insurance will make sense. Most of the buyers who make a healthy down payment will always be at an advantageous position and will therefore not require gap insurance.
If there is a lease then you are not purchasing the car outright, but you would be responsible if the car is stolen or if it is totaled. Here purchasing gap insurance will make sense and most lease contracts require gap insurance.
