Say you bought a $32,000 car with $1,000 down on a 72-month loan. Eighteen months later somebody runs a light and the car is totaled. Your insurer looks up what that car was selling for the day before the crash, subtracts your deductible, and sends the check to the lender. That number might be $21,500. The loan balance, eighteen payments into a 72-month loan at 7%, is about $24,400. The $2,900 in between is yours to pay, on a car that's sitting in a salvage yard.
That's the gap, and gap insurance is the coverage that pays it. It exists because a car loses value fastest in its first few years and a long loan pays down slowest in exactly those years. No money down, a term past 60 months, negative equity rolled in from the last car, or a model that depreciates hard: any one of those puts you underwater for years.
Where you buy it matters more than whether you buy it. The dealer's finance office sells gap as a lump sum, often several hundred dollars, added to the loan. So you're paying interest on insurance, and not just for a year but for the life of the loan, long after the gap has closed. Your own auto insurer usually offers the same protection as an endorsement on the policy, sometimes called loan or lease payoff coverage, for a small amount each policy period. Credit unions sell it cheaply too. Same protection, a fraction of the price, and you can cancel it the month you don't need it.
Read what the version you're buying excludes. Most pay the difference between the insurer's payout and the loan balance, and most don't cover your deductible, late fees, or an extended warranty that got financed into the loan. Some insurer versions cap the payout at a percentage of the car's value, often 25%, which is plenty unless a lot of negative equity got rolled in.
Gap coverage has an expiration date you set yourself. Once the loan balance drops below what the car would sell for, the coverage is paying for nothing. Check it once a year: pull the payoff amount from the lender and look up the private-party value. The day the value is higher, cancel the endorsement. If you bought the dealer's version, ask for a prorated refund of the unused portion, which many contracts allow and few people request.
Leases are different. Most include gap in the lease itself, so check before you buy it twice.
A 48 or 60 month loan rarely needs gap at all, and that's the other half of the car loan term trap. If you're at the dealership tonight, ask what the endorsement costs from your own carrier before you sign the finance office's form.