The Truth About Extended Warranties

The Truth About Extended WarrantiesExtended warranties are everywhere. Even what seem like minor purchases (a $50 coffee maker or a $60 tool) are likely to generate an inquiry at checkout as to whether you would like to purchase an extended warranty. There’s a reason for this; it’s called profit.

Warranties Are Insurance

Warranties are a form of insurance, nothing more, nothing less.

Typically, we insure things we can’t afford to lose. We insure things whose loss would create financial hardship. This is the case for life and disability insurance, and in most cases for homeowners and auto insurance. It’s not the case for extended warranties on many consumer products.

Most new products that have the option of supplemental coverage come with a manufacturer’s warranty against defects in materials and workmanship. The optional warranty typically extends this manufacturer’s warranty, giving you coverage for a longer period from the date of purchase. In some cases, there are additional benefits, such as on-site repairs.

What the additional warranty does is simply provide you with insurance against failure. This may in part duplicate the manufacturer’s coverage and will extend it. There are a few things we should know before we decide if these extended warranties are worth it.

Extended Warranties Tend to Be Expensive

Extended warranties tend to be expensive relative to the value of the property they are protecting. It isn’t uncommon for warranties to be offered at 25 to 30 percent of the cost of the new merchandise. Even 10 percent would be a lot. A quarter or even a third of the purchase cost is extremely expensive.

Cost, however, shouldn’t be our deciding factor: Value should.

The cost is what you pay. Value is what you get. If you get a lot, relative to the cost, then it’s good value. If, however, you get little relative to the cost, then there is little value. Or, we would say, that’s not good value.

We need to consider what you get.

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The Warranty Value Proposition

The warranty value proposition is that you avoid potentially costly repairs by having the warranty to cover those expenses. And this is true in some cases. There are always some people who will be able to use the warranty. Most will never need it. A portion of those who do need it will either forget they have it or will have lost the paperwork or otherwise be unable to determine how to make a claim.

It would be fair to say that fewer than 10 percent of the people who buy an extended warranty on an appliance or a tool ever use the warranty. The value proposition, for the other 90-plus percent, is that they paid for something and received nothing in return. That is not a good value proposition.

That doesn’t tell us anything about the value proposition for those that did purchase the warranty. Having a single claim does not necessarily mean that you come out ahead on the transaction. If the repair is minor, you may have spent more on the warranty than you would have on the cost of the repair.

But we need to think a little more globally.

It’s You Versus the Statistics

If we examine each warranty decision in retrospect of our purchases, we will find that in some cases we would have benefited from the warranty and in others we wouldn’t have. It’s easy to determine after the fact. It’s not so easy, on an individual purchase basis, to make that decision in advance.

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There are a couple of things we do know.

Warranties are extremely profitable for the retailers that offer them. This tells us something significant.

For the retailers, and any insurance company behind the warranty if there is one, the warranty is an extremely good bet. Their value proposition, as the one who collects the premium and pays the claims, is very good. Most of the cost of the warranty is markup; profit if you prefer.

The retailer, and their insurer, are confident that they will pay much less in claims than they collect in premiums.

You, as the purchaser, are on the other side of that equation.

In a series of warranty purchases, the consumer can expect in most cases to receive less in benefits than they pay in costs.

Naturally, there will be exceptions. These are rare. We tend to hear anecdotal accounts of a warranty’s value, but rarely see any detailed analysis of where an individual consumer has come out ahead across a number of warranty purchases on consumer items.

Statistically the retailer wins every time. It’s up to you whether you play.

Options to Extended Warranties

Faced with the option of only being able to lose across time, you might ask if there's a better way.

There is.

Instead of purchasing extended warranties, consider building your emergency fund to cover repair or replacement of these items, as necessary.

Hopefully, you have built your emergency fund. And hopefully you don’t need to dip into it to replace a $50 coffee pot. But what if it’s a $2,500 appliance that needs a $700 repair?

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That’s what your emergency fund is for. Considering that the extended warranty on that appliance would have cost almost as much as the repair, it would be only after multiple repairs — multiple repairs not covered under the original manufacturer’s warranty — that the extended warranty would really have paid off.

As an aside, hopefully you’re not buying upper-end appliances before you’ve built your emergency fund. That wouldn’t be managing your money wisely.

Another consideration is the quality of your purchases. If you buy low-quality items and expensive warranties, you may end up spending more over time than if you buy higher quality items without the warranties. The only time low quality makes sense is if you’re considering the item to be disposable; you need it for a one-time use or some such reason.

Emotion and Warranties

Most of us can’t separate finance and emotion.

For some people, warranties equate to peace of mind. They can’t sleep at night knowing they are exposed to some risk that a product might fail.

This doesn’t make the warranties make financial sense. But for some it may mean they need to spend this money to protect their mental health. Saving money does you no good if it kills you in the process.

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The Bottom Line

Only you can decide whether to purchase extended warranties.

The statistics are that most of your premium goes to someone else’s profit. The value proposition, on a large scale, is not good for the consumer. On an individual purchase basis, you will win some and lose some. Most people will be significantly ahead across time by not purchasing extended warranties. Most people, not everyone.

There are a couple cases where you should consider the details closely, when considering your situation.

Depending on the vehicles you purchase and your usage habits, you may be able to make a case for an auto warranty. Remember the statistics will always favor most people not benefiting; otherwise, the warranty company would go broke.

Choose Your Best Match

Some consumer electronics, phones in particular, are subject to a lot of abuse. Some people routinely crack their screens. In limited cases, people can be better off having the coverage.

The numbers say you shouldn’t do it. The scales are tipped in favor of the retailer and insurer. But you must make your own financial decisions. Most people will be best served by having a sufficient emergency fund and not contributing to the retailer’s additional profits. Individual results will vary. Choose wisely.

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