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Being penny wise and pound foolish

  • Published
  • By Stewart Kaplan
  • 11th Mission Support Squadron
BOLLING AFB, D.C. --  As a financial counselor, it's not often I find myself recommending people spend more money. However, there are times when it's clearly in one's best interest to spend money now to save a larger amount of money later on.

For example, many people I meet with admit that the only money they spend on auto maintenance is for the occasional oil change. They're usually not surprised to hear my mini-speech about looking in their owner's manuals for the maintenance schedule and following it, since neglecting maintenance usually results in bigger repair costs down the road.

There are two other areas where people make a similar mistake and both have to do with insurance -- a place where it's easy to be "penny wise and pound foolish." The two areas are: setting auto insurance liability limits and purchasing gap insurance.

When you shopped around for auto insurance, you probably looked for the cheapest premium you could find. But, is the best auto insurance policy always the cheapest you can get? While it's always wise to look for every possible way to reduce expenses, when it comes to insurance, saving a little can cost you a lot.

Although every state is different, the basics are pretty much the same. We carry liability insurance to protect ourselves when we are at fault. There are required minimums, but we usually have the ability to choose how much protection we want; the more protection, the higher the cost. However, if your only concern is how cheap you can make your premiums, you could find yourself facing a financial disaster. 

How? Somewhere on your auto insurance policy, you will probably see three numbers separated by slashes, for example, 100/300/50. The first number tells you that if you have an accident that's deemed to be your fault and someone other than yourself suffered an injury, your insurance company will pay up to a maximum of $100,000 in compensation to each person. The second number, in this case, $300,000, tells you the maximum amount your insurance company will pay in any single accident to compensate bodily injuries. The final number, in this case $50,000, is the maximum amount they will pay to compensate any property damage in any single accident. Some policies list a single number which is the maximum amount an insurance company will pay out in compensation for any single accident without stipulating how it can be divided up. 

The financial disaster part comes in when you have an accident in which you are found at fault and your liability limits are exceeded. 

What does it cost to increase one's liability limits? It varies, but the difference between the minimum limits and those that are more substantial are less than $100 - $150 a year for most. If you would like to reduce your exposure to risk beyond what the maximum limits allow, insurance companies offer umbrella policies that add an additional $1 - $5 million of protection. These policies are also more reasonable than you might expect.

If you don't know what your liability limits are, it's easy to check. Just look at your policy document and call your agent to discuss whether those limits are right for you. If not, ask how much it would cost to increase them. It might be money well spent.

There is a second area where too many people unnecessarily exposed to the risk of a big financial loss. Most of the time, people don't even know they are at risk. Now, I want to explain why we might want to pay a little more when we buy a car by purchasing something called gap insurance.

What is gap insurance? When you buy a new car and don't put down enough to ensure you have positive equity, you will owe more than your car is worth. In other words you will be upside-down in your loan. If you have an accident in which your car is totaled and you're at fault, your insurance company will pay the replacement cost for your car. The amount they pay will vary, based on what the condition of your car was prior to the accident and what it actually costs to replace your car in the area where you live. The amount you owe on the car has no bearing on that calculation whatsoever. Therefore, if you owe more on the car than the insurance company values your totaled car, you will remain liable for any remaining balance on your loan.

To get an expert opinion, I called my insurance agent to ask her about the practicality of gap insurance. I got an earful. She said she sees those kinds of losses all the time. She said that almost all the time, people are shocked that they have to continue to make payments on a loan even after they receive an insurance payout for their totaled car.

If you think you might be at risk, take a look at your auto loan statement to see how much you still owe. Then make an estimate as to the replacement value of your car. A good place to get an estimate is www.nadaguides.com , but use the trade-in values, not the retail values. If you find that you're upside-down, you're a candidate for gap insurance. As with liability limits, the cost for the additional protection is reasonable. You may be able to purchase gap insurance up to 18 months after initially financing your car. Your auto finance company can give you more specifics.