In both insurance and accounting terms, depreciation is a calculation used to help find the true value of an asset. This is because with certain exceptions most assets lose value over time, in the case of a car this will be through continued use (causing wear and tear on the mechanical parts, weather damage to the exterior, gradual fading/abrading of seats, etc.) and the fact that newer models offer better fuel economy, reliability etc. so your car becomes less desirable over time (in most instances – this isn’t always true particularly for classic cars which may retain their value despite wear and tear).
Why is depreciation important?
When you insure your vehicle against damage or loss, your insurance company is assuming the risk of replacing your vehicle. This doesn’t mean that your insurer will be buy you a brand new car, if it did your premiums would be vastly more expensive.
But it does mean that they want to provide you with an equivalent vehicle so that you can continue your everyday life.
This means in real terms that an insurer will use depreciation to calculate the value of the benefit paid to you in the event of a claim against your policy.
How does that work?
For example you might buy a brand new vehicle that is worth $50,000 the day you buy it, and your insurer might decide that such a vehicle is allowed to depreciate over 10 years.
That means for every year older the vehicle would lose 1/10th of its value, in this case 1/10th of $50,000 is $5,000.
So if you make a claim after five years of driving your insurer would consider the depreciation on your car to be 5 x $5,000 which is $25,000. That means the maximum benefit they would pay to replace your car is $25,000.
Actually this example is very much over simplified and depreciation calculations for cars are a little more complex partly because as soon as you drive your new car home, it loses a large chunk of its sticker price value on the second hand market (and depreciation reflects real world pricing).
Why does this matter?
Depreciation shouldn’t affect you too much unless you have a car where the balance of any finance outstanding on the vehicle is going to cost you more than the value of your insurance benefit after depreciation. In this case you should consider gap insurance to make sure you’re not paying for a car that you can’t drive anymore.