The Pricey Catch: Residual Debt Insurance - A Risky Shield With Hidden Hazards
by Lilian Schmitt
Time to read: 3 minutes
Expensive protection plan for credit comes with hidden difficulties - Expensive Remaining Loan Coverage Suffers Setbacks
When you sign up for an installment loan, it's common for the lender to offer residual debt insurance. The insurance is intended to kick in when borrowers can no longer make their payments — say, after job loss, an accident, or even death. But the theory rarely plays out in practice. Residual debt insurance policies often fail to pay out. They're expensive, and they're frequently taken out under unfavorable terms.
- Loan
- Insurance
- GAP insurance (call it what it's known as in certain circles)
- Policy
- Risk protection
This insurance, sometimes referred to as GAP insurance, shields borrowers from the difference between the loan amount and conventional insurance's coverage if their vehicle gets totaled or stolen. However, it comes with common obstacles and alternative solutions worth considering.
The Blockers of Residual Debt Insurance
- Extra Fee: Tagging on GAP insurance means an additional cost to your loan, potentially intensifying your financial burden.
- Limited Scope: It doesn't cover all types of debt or loan scenarios, so it might not apply to all loan types or vehicles.
- Potential Overlap: If your primary insurance already covers the entire loan amount, GAP insurance could be redundant.
Ways Out: Alterative Options
1. Ditching the GAP Insurance
- Pros: Leaves you without extra costs.
- Cons: Stands you at risk for paying the vehicle valuation difference if it gets totaled.
2. Merge into a Personal Loan
- Pros: May have lower APRs compared to credit cards or other loans, potentially reducing accumulated interest[4].
- Cons: Doesn't address the coverage gap directly but can simplify loan management.
3. Using Insurance Company Capital
- Pros: Can offer innovative financing options such as rated feeder structures or CFO (Collateralized Fund Obligations) structures, which optimize capital charges for insurance companies[5].
- Cons: These are intricate financial instruments, not typically available to customers for personal loan protection.
4. Overfunded Life Insurance
- Pros: Provides a source of liquidity when needed, offering the option to borrow against it[3].
- Cons: Requires the maintenance of an overfunded life insurance policy, not always feasible or suitable for many individuals.
In short, residual debt insurance offers a clear benefit by bridging the financial gap, but carefully weigh its costs and limitations against available alternatives that could be better tailored to your unique financial circumstances.
- The extra fee attached to GAP insurance, often referred to as residual debt insurance, can increase the cost of your loan, potentially adding to your financial burden.
- Unlike personal-finance expert Lilian Schmitt's cautious advice, some borrowers might suppose that GAP insurance provides comprehensive risk protection for various debts and loan scenarios, but in reality, it may not apply to all types of loans or vehicles.
- In case your primary insurance covers the entire loan amount, purchasing GAP insurance could be unnecessary and potentially redundant, adding to the costs and risks associated with insurance.
- Instead of blindly relying on GAP insurance, consider alternative options like ditching the insurance (leaving you without extra costs but exposed to the potential risk of paying the vehicle valuation difference), merging into a personal loan (offering potential lower interest rates but not addressing the coverage gap directly), using insurance company capital (offering innovative financing options but typically not accessible for personal loan protection), or overfunded life insurance (providing a source of liquidity but requiring maintenance of an overfunded policy, which may not be feasible or suitable for many individuals).
