An offer of an extended warranty has become the norm for many retailers of big-ticket purchases. By offering coverage beyond the length of the manufacturer’s original warranty, these warranties often appeal to thrifty consumers who make exacting decisions when buying expensive items like large appliances and electronics.
When you’re pulling out your wallet to pay for a new refrigerator, big-screen TV, or treadmill for your home gym, it’s hard not to be tempted by the extended warranty sales pitch–even if it increases the cost of the purchase by hundreds of dollars.
But are these warranties worth the price? In most cases, the benefits of these warranties don’t extend beyond the profit margins of the companies that offer them.
- Extended warranties are a type of insurance to cover the cost of repairing or replacing products that have manufacturer defects.
- They are great moneymakers for retailers, but relatively few customers ever need to use them.
- Remember, many new appliances and electronics come with a one-year warranty
An Extended Warranty Is Insurance
An extended warranty works like an insurance contract for the product you purchase and may be offered by either the product’s manufacturer or by the retailer, which contracts this service out to an insurance company.
While the price of an extended warranty often seems like a bargain compared to the steep price of repairs, it has actually been carefully considered through actuarial analysis by the company that offers it.
The number of washing machines that needed repairs within three years of their purchase dates.
In other words, the company uses probability and statistical methods to calculate the likelihood that your new refrigerator or flat-screen television will require repairs. This figure is weighed against how much those repairs would cost in order to arrive at the price that the company will charge a consumer for a warranty on a particular item.
Needless to say, the company offering the policies is looking to come out ahead.
Probabilities and Profit Margins
Extended warranties are sold to consumers for a profit and can be big money-makers for retailers. Profits from warranties can account for as much as 70% of a retailer’s operating income, compared to only 10% for the products the warranties cover.
For every dollar you spend on an extended warranty at a retailer, $0.70 goes to the retailer and the remaining $0.30 goes to the insurance company. Because the insurance company also expects to profit from the agreement, it is clear that it doesn’t expect to have to make very many payouts.
The Hard Numbers
In fact, a Consumer Reports survey of 38,000 consumers found that only 8% of camcorders, stove ranges, dishwashers, and refrigerators required repairs within the first three years after they were purchased.
Since these warranties cost almost nothing to market and are rarely used, they are a simple way for retailers to boost their bottom lines.
Suppose you are in the market for a new washer and dryer. You choose a high-end set that costs $2,250. The salesperson offers you an extended warranty that will cover the cost of services and repairs for three years and includes a replacement guarantee if the product can’t be fixed. The warranty costs $660.
If you’re tempted to shell out for this warranty, it’s because you know that the cost of in-home repairs for this set of appliances would add up fast if you had to pay for them yourself and could easily exceed $660.
What’s the Risk-Reward Ratio?
The concept of weighing risk and reward is a key principle in investing: taking on more risk increases an investment’s possible return. The same is true for warranties.
In a best-case scenario, you will purchase the washer and dryer but turn down the warranty and your new purchase would not require repairs within the three-year period that the warranty would have covered. If this occurs, you save $660.
Of course, if you don’t buy the warranty, the worst-case scenario is that your new appliances require repairs within three years and those repairs cost more than the $660 warranty.
According to an evaluation by Consumer Reports, your washing machine has a 22% chance of needing repairs within the first three years. The dryer is even more reliable, with only a 13% possibility that it will break down within that period.
If your appliance retailer (and its insurance company) is willing to bet on these odds, why shouldn’t you?
Instead of handing your money over to the retailer, put the $660 aside in case your new purchase requires repairs down the road. This way you’ll collect interest on your own money and you’ll also get to keep it if you beat the odds.
The Flip Side of Warranties
Manufacturers and retailers tend to push warranties because they’re profitable. You need to decide for yourself whether the risk outweighs the reward. If a warranty gives you peace of mind, it may be worth the money.
Don’t forget that many products come with a standard manufacturer’s warranty, free of charge. This warranty usually applies to the first year of the product’s life. It should cover you if the product turns out to be defective.
Furthermore, if you buy an extended warranty on top of the initial warranty, both warranties start immediately, so you’re paying twice for coverage for the first year.
Fix or Buy New?
Also consider the replacement cost of the product you are buying, particularly when it comes to electronics. As these goods continue to improve and their prices continue to drop, your warranty could easily end up costing more than you would pay to replace the product when it fails.
Although warranties may seem like an act of customer service that companies extend to consumers, they are actually carefully calculated to be profitable for the companies that offer them.
Before you agree to insure your next big-ticket purchase against failure, carefully consider the likelihood that the product will fail, as well as how much it would cost for you to repair or replace it.
In many cases, the odds are in your favor and your best course of action is to bet that your appliances and electronics will outlast the warranties.