Is gap insurance worth it when buying a car?

When a prospective buyer walks into a dealership to buy a car, they are often inundated with “upsells.” Upsells in the auto sales industry can include anything from extended warranties to service plans to extra goodies on vehicles such as DVD players or heated seats.

One common upsell in the auto industry is gap insurance. But what exactly is gap insurance? Is it really a necessity, or is it just another way for car dealerships to make money?

What is gap insurance?

Gap insurance is an additional insurance policy that is offered on vehicle loans. Gap insurance policies do not replace your primary auto insurance policy, but instead provide coverage over and above your primary auto insurance policy. Typically, a dealer works to sell gap insurance on vehicle sales that:

• Include a low payment or zero-down payment
• Have a loan term of longer than 60 months
• Have buyers that only qualify for a high interest rate loan

The purpose of gap insurance is to cover the amount on a loan that is the difference between the vehicle’s value and the amount owed. Simply put, if you’re expected to be upside-down on your car loan quickly, the dealership will likely offer you a gap insurance plan option.

Read more: How to sell an upside-down car

How do I know if I need a gap insurance policy?

If you are offered the option to purchase gap insurance by a car dealership or an insurance company, it’s a good idea to ask yourself some questions before saying “yes” to this type of insurance. Some of the questions you can ask yourself might include:

• Will I be carrying a loan on the vehicle? If you’re paying cash for the vehicle, gap insurance isn’t necessary.
• If I am taking a loan out for the vehicle, is the car worth less than what I owe on it? If you’re financing a vehicle for a dollar amount that’s larger than what the vehicle is worth according to blue book standards, Gap insurance can be a good idea. However, if you’re financing the vehicle for less than the car is worth, gap insurance isn’t usually necessary.
• Is the term of my new loan longer than 60 months? If the car loan term for your vehicle purchase is longer than 60 months, you’ll likely be upside-down on the loan before you have the vehicle paid off. In that case, it may be a good idea to purchase gap insurance.

By asking yourself the questions stated above, you can help determine whether or not gap insurance is necessary in your auto purchase scenario.

A better way

One way you can avoid the gap insurance purchase debate for certain is to avoid financing vehicles altogether. In my family we buy reliable used cars that we pay for in cash instead of purchasing vehicles that require financing.

Why do we buy cars that way? Two words: opportunity cost.

What is opportunity cost? Opportunity cost is the loss of money you could be using to grow wealth because you’re spending it on the finance of a vehicle or other large expenditure.

Let me take a brief moment to explain the impact of opportunity cost.

If you finance a new car with an auto loan based on the average numbers of auto loan borrowers today, you’ll be taking out a loan for approximately $28,381, with an average term of 66 months, and a payment of approximately $482 (assuming an interest rate of 4.15%).

At the end of the term, you’ll have paid nearly $31,800 plus the down payment for that car – over $3,400 in interest charges alone.

If you were to have invested that $482 for seven years at an interest rate of 5%, you would have a total in your investment account of $49,004.

So what would be the total of your opportunity cost loss?

What you paid for the car loan including interest:	$31,792
What you missed out on by not investing:	$49,004
Total opportunity cost loss:	$80,796

So in reality, that vehicle (which at the end of six or seven years is probably only worth a few thousand dollars) cost you nearly $81,000 plus any down payment you may have put on the vehicle.

And if you’d taken gap insurance on that vehicle loan, you can add that as an additional cost to your losses. So instead of buying a vehicle that is financed so heavily that gap insurance is needed, I recommend choosing instead to buy a reliable use car and pay for it in cash.

Read more: 5 things to know before buying a used car

Here are some ideas for saving cash quickly to buy a reliable used car for $5,000 or so.

• Declutter your home and sell the things you no longer need or want.
• Work a second job or do some side hustle work for six to 12 months.
• Cut expenses to the bare minimum temporarily so that you’ve got extra money to put into savings for a car.
• Work overtime at work if it’s available in order to save extra cash.

Once you warm up to the idea of never having a car payment again, I think you’ll find living a life without car debt much less stressful. And you’ll avoid having the debate about whether or not you need gap insurance forever!