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Mix low down payments and long-term auto loans, then add a dash of rapid depreciation on new cars, and you have a recipe for financial pain. If your car is totaled in an accident, you could owe more on the note -- perhaps thousands of dollars more -- than you'll get from the insurance company.
For a look at a worst-case scenario, assume you bought a 2004 Chrysler Sebring for $18,500 last fall, with $1,000 down and a five-year loan at 4% interest. After six months and 5,000 miles, a crackup totals the car. You still owe the bank $15,903, but the vehicle is worth just $12,000 or so. You'll need $4,000 (plus the amount of the deductible) just to pay off the loan.
Being "upside down" in a loan -- that is, owing your lender more than the car is worth -- is becoming increasingly common. "More people are upside down longer because they stretched out their loan and minimized the down payment," explains Charlie Vogelheim, executive editor of Kelley Blue Book, which tracks used-car values.
Gap insurance
To solve the potential problem, lenders and insurance companies offer "gap insurance," which covers the difference between a car's cash value when it's totaled and the amount you still owe the lender. Gap insurance has long been a part of car leases: Because leases often require no down payment, an early-in-the-lease accident or theft leaves an enormous void between an insurance payoff and what's owed on the contract. But now the insurance is increasingly sold to new-car buyers.
Some insurers, including Progressive, offer a rider to your regular policy that will pay up to 25% more than the car's depreciated value if you owe more on your loan than the car is worth. Progressive adds 10% to your collision premium for the rider (the average cost is $45 per year). Other companies charge a flat fee of $14 to $20 per year for the coverage, says Tom Schneider, an independent insurance agent in Gahanna, Ohio. These fees usually remain the same, no matter how big the gap is.
A few companies provide extra coverage in their standard policies for no additional charge. MetLife, for example, will pay the full cost to buy a new car if you total your car within the first year and have driven less than 15,000 miles. The company also offers a gap rider that kicks in no matter when a car is totaled. It adds 7% to your comprehensive-and-collision premium.
Jim Gleeson of Naperville, Ill., put enough down on his Ford Ranger that he didn't need gap insurance. But the replacement coverage in his MetLife policy proved valuable when his 20-year-old son, Nick, totaled the pickup when it was ten months old.
Gleeson paid about $21,000 for the truck, but the insurer determined it was worth just under $15,000 when the crash occurred. Most insurers would have paid only that amount. But MetLife paid the full $21,000 (minus a $250 deductible).
Who needs it?
Gap insurance is worth the cost only if you face a potential gap of several thousand dollars. You generally don't need it if you make a down payment of 20% or more. In fact, GMAC Insurance and Ford Credit won't sell the policy if you do.
To determine your potential risk, go to Kelley Blue Book's Web site and look up how much one-year-old models of the car you're considering are selling for. Samuel Bennett, an insurance agent in Columbia, Mo., suggests you subtract 20% from the estimated value for a better idea of how much your insurer would be likely to pay. Then compare that amount to what you'd owe on your loan after one year. (Use the "How Much Will My Vehicle Payments Be?" calculator at Kiplinger.com to see the balance at various points in a loan's life.)
If the difference is several thousand dollars, consider gap insurance. And remember, you may need the coverage for just a year or two. As time passes, the size of the gap diminishes.
--Research: Elizabeth Kountze
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