If your car’s totaled, most car insurance companies reimburse you for the actual cash value of your car, not the replacement cost. Let’s review the difference.

Actual cash value vs. replacement cost
Actual cash value (or ACV) is calculated by determining an item’s original value minus the amount it has depreciated after you bought it . Replacement cost, on the other hand, is the amount of money necessary to replace damaged, destroyed, or stolen property with a new item.

We’ll use an example scenario* to help explain the difference. Imagine you buy a car for $25,000. You drive it without incident for 5 years when suddenly bam! A disoriented deer runs out into traffic and into your path. Don’t worry, you and the deer are okay. Unfortunately, your car is totaled.

You file a claim with your insurance company and are relieved to learn that deer run-ins fall under comprehensive coverage. That coverage, however, will pay for the car you have now, not the car you had 5 years ago. And after 5 years of standard wear and tear alone, your car’s probably worth around $9,000.

How actual cash value is determined
Of course, all cars lose value as they age, but not all cars age equally. If your car is totaled, the insurance company considers the condition the car was in just before the accident, including mileage, option packages, and overall physical condition (think peeling paint, torn seats, rust … anything that’s not a direct result of the accident).

In some cases, you may be reimbursed for things like title fees, registration fees, and sales tax. But this varies by situation and state, so it’s best to get the details from your insurer. Once your insurance company determines a settlement amount, they’ll subtract your deductible before paying out your claim.

But what if your car’s leased or financed? Sometimes what you owe on the lease is more than the car’s ACV. Good thing there’s a coverage for that!

Loan/lease coverage
Let’s go back to your shiny, new $25,000 car. This time, rather than buying it outright, you decide to lease it. You put $1,000 down, leaving you with $24,000 to pay off.

Several months later, that same distracted deer dashes onto the highway and totals your car.

Your car insurance company will pay the actual cash value of your car, which has a new value after standard wear and tear depreciation of $20,000. That’s a nice chunk of change under normal circumstances, except, according to your last loan statement, you still owe $23,000 on your car! That leaves $3,000 — plus your $500 deductible — for you to cover out of pocket.

Loan/lease gap helps cover some of the difference between what you owe on your car and what your car insurance covers. It’s common for insurance companies to cover 90 percent of the difference. If you’re a policyholder and you purchase this coverage, it’ll pay up to 25 percent of the car’s ACV.** In the scenario above, 25 percent of $20,000 is $5,000 (but, of course, you’d receive only $3,000 since that’s what you owe).

Gap coverage doesn’t include expenses like unpaid finance charges or excess mileage charges, but it can help rescue you from dipping into that vacation fund to cover the rest of your lease.

If you’re considering adding this coverage to your car insurance policy, check your loan agreement first. Many finance companies automatically include it as part of your lease contract, which means you may already be covered.