Gap insurance covers the difference between what the car is worth and what you owe on the car. It comes into play if the car is stolen or totalled (damaged to the point that repair would cost more than the car is worth) while the owner is still making payments.
How gap insurance worksLet's say you buy a new car for $20,000. You put $500 down and your payments are $350 per month. Six months after buying your car, it is involved in an accident and totalled.
Your collision insurance company determines that your six-month-old car is now worth only $16,500. They will pay you that amount (less your collision deductible if the accident is your fault). You've made six monthly payments plus your down payment, for a total of $2,600; you still owe $17,400 on the car. In a case like this, gap insurance would pay the $900 difference between what collision insurance covers ($16,500) and what you owe on the car ($17,400). If you did not have gap insurance, the extra $900 would come out of your pocket. (Note however, that if your insurance company determines that your deductible applies, the cost of the deductible is your responsibility -- gap insurance won't cover it.)
Gap insurance for lessorsIn the case of a lease, even though you aren't buying the car outright, you are responsible for the cost of the car if it is stolen or totalled. Because lease payments -- and therefore the amount of money you have tied up in the car -- is significantly lower, the difference between what you have paid and the value of the car can be huge -- therefore gap insurance is much more critical for a lease. In fact, many lease contracts require it.
Gap insurance for buyersFor buyers, gap insurance only makes sense if you expect to be "upside down" on the car (you owe more than it is worth). If you made a low down payment, if you bought a car that depreciates rapidly, if you have a high interest rate or if you rolled over other costs, such as money owed on a trade-in, into your new-car payments, gap insurance makes sense. Most buyers, particularly those who made a healthy down payment, will always be right-side-up on the car, and therefore don't need gap insurance.
Who should buy gap insurance:People who are leasing a car or who expect to owe more than the car is worth for a significant amount of time.
Who should not buy gap insurance:Buyers who have arranged their down and monthly payments so as to ensure that they won't be "upside down" on the car for any significant period of time.