If your car is written-off or stolen, your comprehensive car insurance will pay out what the car is worth at the time that this happens. But if you’re still paying off your car, the payout is often less than what you still owe to the bank – this is especially true in the early years of your car loan. Credit shortfall cover, which you can add to your comprehensive car insurance, will protect you from having to pay the difference out of your own pocket.
In this blog post, you can find out what shortfall cover is and when you’re most at risk of having a shortfall between your loan and the insurance payout.
What is shortfall cover?
When you make a claim for the total loss of your car, credit shortfall cover, also known as gap cover or top-up cover, bridges the gap between the money you still owe the bank on your loan, and the amount your insurer pays out – which is based on the current value of your car.
Credit shortfall cover ensures that you don’t end up out of pocket if your financed car is written off or stolen.
But why would my insurance pay me less than what I owe on my car?
If your car is written-off or stolen, you will be paid what your car is worth (the insured amount) at the time of the loss, which can be lower than what you still owe on your car loan. This is especially likely shortly after you’ve bought your car. This is due to a few things:
- Some banks add some of the future interest at the start of your payment term or build in early settlement penalties.
- Dealerships and banks sometimes include the initiation and admin fees to your overall loan.
- The biggest reason is depreciation. A car loses most of its value early in the loan period (specifically in the first three years of its life). So while the outstanding balance on your loan decreases with each month, the amount you owe can still be significantly higher than the value of your car.
TIP: Ask your insurer what basis they use to value your car. Retail value is the highest value for which it can be insured for, followed by market value and then trade-in value (the lowest value of the three and most likely to lead to a shortfall).
Depending on a car’s make and model, it’s been said that it can lose as much as a third of its value in the first year, and as much as half its value in the first two years. Keep in mind that how much a car’s value depreciates is very dependent on the make and model, plus external factors outside of your control, like the supply and demand of the type of car you have.
How do you figure out whether you need shortfall cover or not?
1. You have a balloon payment
A balloon payment is a large lump sum that needs to be paid at the end of the repayment period. It lowers your monthly repayment, but it also slows down how quickly your loan reduces. So, if your car is written off, it’s likely that your insurance payout won’t be enough to cover your loan. If you have chosen to add credit shortfall cover to your comprehensive cover, the balloon payment will be covered in case of theft or write-off.
2. You had no deposit or it was less than 20%
The bigger the upfront deposit you give, the smaller your loan will be. This usually means that the value of your car is higher than that of your loan. If you choose to make a small or no deposit, the opposite is true — the value of your loan is likely to be higher than the value of your car, which will put you at risk for a shortfall.
3. The term of your loan is five years or longer
Having a long repayment term means that your loan amount decreases slowly, increasing the risk that the value of your car will depreciate quicker than your loan.
So, the longer the term of your loan, the greater the potential 'gap' between what you owe and the value of your car, and the greater the need for shortfall cover.
4. You bought a brand new car
If you’ve just bought a new car, then you’ve probably heard that these cars decrease in value faster than older cars. For this reason, the risk of a shortfall will always be higher for new cars, as the gap between what you owe and what your car is worth can be quite significant, especially early on in your loan term.
5. Your car is insured for market or trade value
Some insurers insure cars at market or trade value. At Naked, we insure cars at their retail value, but other insurers might rather insure your car at (the lower) market value or (the even lower) trade value. Opting for a lower insured value increases your potential for a shortfall.
6. You have a high interest rate on your loan
The higher the interest rate charged, the greater the potential for a shortfall. Why? Because this reduces the rate at which you repay your loan and the slower you repay your loan, the greater the shortfall risk if something were to happen to your car.
This is a less significant factor than some of the others though.
7. You’re in the first 24 months of your car loan
If you are within the first 24 months of your loan term, and any one of the other factors above applies to you, you would most likely have a shortfall risk. The above rules aren’t foolproof, but they should give you a good idea of whether you need shortfall cover or not.
If you’re still unsure, check with your insurer or your finance house — they can help to point you in the right direction.
At Naked, you can simply add shortfall cover by tapping a button on your existing policy in the app. And when you no longer have a shortfall, you can remove the cover as easily as you added it on the app (and of course reduce your premium instantly!).