When you’re buying a used car, depreciation can be your best friend. When you’re selling a used car, depreciation can be your worst enemy. And, if your car is declared a total loss and you agree to the settlement amount, you are in effect selling a used car to the insurance company.
That’s the short answer to why a total loss payout can be less than you owe.
There’s a bit more to it though.
Depreciation
You may have heard every new car loses a certain percentage of its value the moment it is sold. This is true because if you had to sell it back to a dealer, they’d only offer you the wholesale price in order to leave themselves room in the deal to sell the car again at a profit.
“Aha,” you say. “I’ll just sell it to a private party.” Well, why would anyone pay you the price of a new car for a used one, when they could go to a dealer and get the same price, along with all of the other benefits of purchasing a brand-new car, from a dealer?
This is the primary reason the value of a car goes down when it’s purchased. It then continues to fall with each succeeding year because newer — presumably more desirable — models come along in its wake.
Actual Cash Value
Most auto insurance policies only cover the actual cash value of the car.
When an insurance company offers you a payout after declaring your car a total loss, they are in effect agreeing to buy it as a used car for what it was worth during the instant before the incident.
In other words, they’ll offer what anyone would have been willing to pay you for it in pristine condition at the moment before the accident. Which, basically is the amount of money your car is worth when depreciation is taken into consideration.
Loan Amount vs. Actual Cash Value
OK, so to keep the math easy, let’s say you bought the car for $10,000. You made a down payment of $500 and your monthly payment is $100.
Five months later, the car is involved in a catastrophic accident and it’s going to cost $9,500 to fix it.
However, depreciation has kicked in and knocked the actual cash value of the car down to $8,000. This means it’s going to cost $1,500 more than the car is worth to repair it. This disparity leads the insurance company to declare the car a total loss.
Meanwhile, your down payment and your monthly payments have added up to $1,000, which means you still owe $9,000 on the car. If you accept the payout, you’ll need to come up with the additional $1,000 to pay off the loan on your own because you are still legally obligated to make your monthly loan payments to the bank or financial lender until the loan is paid off.
Gap Insurance
This scenario is actually a lot more common than you might think. This is why you should always purchase gap insurance when you agree to an extended loan period or make a small down payment.
This coverage is typically a requirement of the best lease deals for the same reason. Leasing companies want to be sure they get the full value out of the car.
Once you understand why a total loss payout can be less than you owe, the value of gap insurance becomes apparent as well. After all, the last thing you want to have to do in this instance is making 10 more payments on a car you can’t drive.
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