A large auto loan or lease can help cover the high costs, but it may leave you "underwater" — owing more than the car is worth — if it is totaled or stolen. While collision and comprehensive insurance will pay for damage or theft to your car, both coverage types will only pay up to the current market value of your car minus your deductible, leaving you to pay the rest. This can amount to thousands of dollars in some cases.

Your car dealer may recommend gap insurance, which will cover the difference so you don't have to. Gap insurance can be a wise decision in today's volatile auto market. However, the cost of this additional coverage varies greatly, so shop around before you buy.

Higher car prices could mean a bigger gap

The term "gap insurance" refers to guaranteed asset protection. It pays the difference between the market value of your vehicle and the amount owed on your car loan or lease. Because cars depreciate quickly, you may owe more than the value of your vehicle, particularly during the first few years of repayment.

According to Caleb Cook, vice president of consumer lending at Massachusetts-based Digital Federal Credit Union, trends in the current auto market can make that gap unusually large. These are some examples:

• Shortages. Because of a microchip shortage caused by a pandemic, car manufacturers are unable to meet the demand for new vehicles. Because there are fewer new cars available, sellers can charge higher prices for any vehicle a buyer can obtain, whether new or used.
• Surcharges. According to Brian Sullivan, an independent insurance broker at Avail Insurance Solutions in Oakland, California, some new-car buyers end up paying a surcharge "anywhere from $5,000, $10,000, or even more for luxury cars" above the manufacturer's suggested retail price, or MSRP.
• Lengthy loans. To make high-priced cars more affordable, lenders are extending their finance terms, with seven-year car loans no longer unusual, Cook says. This results in lower monthly payments, but the loan balance remains higher for a longer period of time, while the car's value depreciates.

According to Cook, these factors increase the likelihood of being "upside down" on a car loan or lease, owing more than the car's value. "People are taking out longer-term financing, larger loan amounts, paying slightly more than MSRP or paying a premium for a used car," he says. "Their upside-down potential is much greater."

While used-car prices are high, shoppers may not be concerned about vehicles losing value, but this effect is likely to be temporary. Those who paid high car prices will be particularly vulnerable when the auto market eventually corrects itself, according to Sullivan. Prices may fall, widening the gap between what a car is worth and what is owed on it.

Is gap insurance worth it?

"Anyone who buys or leases a new car or truck should consider gap insurance because the vehicle's value begins to depreciate the moment it leaves the dealership." In fact, most cars lose 20% of their value in a year," said Loretta Worters, vice president of media relations at the Insurance Information Institute, in an email.

You should think about gap insurance in particular. Worters stated that if:

• You financed for at least 60 months.
• You paid a down payment of 20% or less.
• You bought a car that depreciates quickly.
• You rented the car. In fact, gap insurance may be required by some leasing agreements.

You don't need gap insurance if you don't have a car loan or lease, or if you made a large down payment.

What to know when purchasing gap insurance

Gap insurance can be purchased from your insurer, your lender, or the car dealership, but Sullivan believes it is most cost effective to do so through your insurer. "The premium can be very low." "Typically, gap coverage can start at $19 per year," Sullivan says.

Purchasing gap insurance through a dealer or lender, on the other hand, can cost $500 to $700 as a one-time fee.

Typically, gap insurance is only required for two or three years while you pay off your car loan. When your loan balance equals the actual value of your car, you should cancel your gap insurance policy.

If you did not purchase gap insurance when you purchased your vehicle, you may be able to do so later. Gap insurance is available from some insurers for vehicles that are no more than two or three model years old.

Gap insurance, in Cook's opinion, is worth considering.

"This current environment will not last forever." "We'll figure out the shortage," he says. "In the short run, I believe the gap is more important now than it has ever been."