Gap insurance, or gap auto insurance, is form of insurance that covers the difference between the calculated value of your car and the amount you still owe on a loan or lease if your car is totaled.

Understanding Gap Insurance

If you purchase a car using a financing plan or loan that covers most of the cost of the vehicle, you may find yourself upside down on the loan after a few months of vehicle depreciation. In other words, you'll owe more for your destroyed car than the insurance company deems it to be worth.

If you buy a car and make only a small or no down payment, your loan will cover most of the purchase. But if your car is totaled due to an accident, vandalism or natural disaster within the next few months or years, your insurance company may determine that the value of the car is less than what you initially paid for it--and less than you still owe on your loan.

If this happens, you'll be left with a gap, plus the deductible on your insurance policy, that you'll need to pay to the lender out of your own pocket for a car that you no longer own. This can be especially difficult if you find yourself needing to purchase another car right away.

Upside-Down Loans

New cars depreciate rapidly. Depending on your finance plan, the principal on your car loan can diminish comparatively slowly. It's not unusual for new car owners to be underwater for a brief time during the early life of both the car and the loan. This is a financially risky time for car owners, hence the rise of gap auto insurance riders.

Many new car owners ask themselves, "What is gap insurance and is it right for me?" The answer is usually "yes" if you make only a small down payment on a relatively large loan for a new car. Within three months, a new car may be worth less than 30 percent of its value on the day it leaves the lot.