What is gap insurance and how does it work?

Guaranteed asset protection insurance (otherwise known as "gap insurance") is a type of car insurance that protects you if the value of your vehicle is less than the balance of your auto loan. With this coverage, if your car is totaled or stolen, you won't be stuck paying a car loan for a vehicle no longer in your possession. Gap insurance is an optional add-on for most drivers — however, if you're leasing a car you may be required to purchase it.

CNBC Select has the details on how gap insurance works, how much it generally costs and when it makes sense to buy it.

When you lease a vehicle or use an auto loan to purchase one, you may be required to have comprehensive and collision insurance. However, these coverages only protect you up to the value of the vehicle as assessed by the insurance company. Depending on your situation, you could owe more on a car than it's worth and if it's totaled the insurance payment may not cover the entire loan. This is where gap insurance kicks in and covers the difference after you pay the deductible.

Gap insurance is only an option when you're leasing a vehicle or purchasing one with a loan. If you're purchasing a car with cash, it's not a consideration.

However, just because you're taking out a car loan, that doesn't necessarily mean you'll need gap insurance. You should always look at the number for your specific situation, but gap protection is more likely to make sense when:

• You have a longer-term loan
• You have a high interest rate on your loan
• You had no down payment or a small down payment
• You'll put a lot of miles on the car
• The car model is likely to depreciate quickly

Deciding if you need gap insurance largely boils down to whether your vehicle will lose its value faster than you'll pay down the loan. The principal loan balance is paid off more slowly on auto loans with high interest rates and longer repayment terms, which increases the likelihood that your car's value drops below what you owe.

One way to help avoid getting underwater on your car loan is by getting one with good terms in the first place. CNBC Select has ranked PenFed as the best overall auto loan provider, thanks to the credit union's affordable rates and flexible terms. MyAutoloan is another solid choice to shop for a loan, especially if you want to quickly compare different offers from multiple lenders — the marketplace will match you with four prequalified loans after you fill out a form.

The cost of gap insurance varies depending on your circumstances and the car's value. There's also a huge difference in cost depending on where you purchase it. You may be able to get it as an add-on to your auto insurance policy or purchase it through the dealer, a bank or a credit union.

Typically you'll get a better deal on gap insurance when you purchase through your car insurance provider. According to research by independent insurance agency Tricor, you can expect to pay about 5% to 7% of your comprehensive and collision coverage. The most expensive way to get gap insurance is usually through a car dealership or an auto lender. That's largely due to the gap insurance premiums being rolled into your loan, which means you're effectively paying interest on the cost of your insurance.

There may be situations where you could be required to have gap insurance on a leased vehicle. But usually getting gap insurance is optional and makes sense if the value of your loan outpaces the value of the car.

The larger question is whether it's a good idea to have that mismatch between the loan amount and the car's value. "If you're in a place where gap insurance seems sensible, it means that you're probably ... spending too much on the vehicle relative to what you can afford," says Douglas Heller, director of insurance at the Consumer Federation of America, a non-profit consumer advocacy group. Sometimes circumstances will leave you little choice but to take a loan with a higher interest rate or longer term, and gap insurance helps protect you when you owe more than the car is worth. But financing a less-expensive vehicle (such as a used car) might eliminate any need for gap insurance in the first place.

There are also alternatives to gap insurance, such as better car replacement and new car replacement insurance. These types of coverages replace your vehicle when it is totaled, but have strict mileage limits and other requirements. They also won't necessarily be more cost-effective or useful than gap insurance.

Gap insurance is a type of car insurance you can purchase to augment collision and comprehensive coverage, and protects you financially if the value of your auto loan is greater than the value of your car. If your vehicle is totaled, gap insurance covers the difference between your car's value and your loan's balance. The cost of this coverage varies depending on where you purchase it, and the cheapest option is usually to get it directly from your auto insurance provider and skip the gap coverage offered by car dealers.

At CNBC Select, we work with experts who have specialized knowledge and authority based on relevant training and/or experience. For this story, we interviewed Douglas Heller, director of insurance at the Consumer Federation of America, a non-profit consumer advocacy group.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every insurance article is based on rigorous reporting by our team of expert writers and editors. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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