Definition
The phrase GAP insurance is used to describe an insurance policy on an automobile that would ensure the entire balance on a loan could be repaid if the policyholder were involved in an accident and the cost to repair the vehicle exceeded the car's fair market value and outstanding balance on the loan.
Explanation
Also known as Guaranteed Auto Protection, GAP insurance covers the difference between what an individual owes on a car loan and the fair market value of the car. Typically, automobile insurance policies cover repair costs up to a car's fair market value. If the outstanding principal on a car loan is greater than the car's fair market value, there is a "gap." The money received from the automobile insurance policy would not be sufficient to repay the balance owed on the loan.
Example
A two year old car has an outstanding loan amount of $12,000 on the day of the accident. The owner used the car for long commutes to work, and the high mileage vehicle's fair market value was $8,000. The cost to repair the car was determined to be $10,000.
The collision portion of the automobile insurance policy will pay for repairs up to the fair market value of the car. The owner also purchased a GAP insurance policy, which paid the additional $4,000, enabling the owner to repay the outstanding balance on the loan of $12,000.
If the policyholder did not purchase GAP coverage, they would be responsible for the $4,000 difference between the fair market value of the vehicle, and the outstanding balance on the loan.
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