A Get Rich Slowly reader pointed to a Washington Post article about extended warranties. “Unwarranted” discusses the psychological reasons consumers buy these products, explores industry profitability, and emphasizes that most experts recommend against purchasing extended service contracts.

The decision to buy an extended warranty [...] defies the recommendations of economists, consumer advocates and product quality experts, who all warn that the plans rarely benefit consumers and are nearly always a waste of money.

“The things make no rational sense,” Harvard economist David Cutler said. “The implied probability that [a product] will break has to be substantially greater than the risk that you can’t afford to fix it or replace it. If you’re buying a $400 item, for the overwhelming number of consumers that level of spending is not a risk you need to insure under any circumstances.”

Why are extended warranties a poor idea?

  • They are not warranties. They are “insurance products on which the premiums are paid in a lump sum at the time of purchase”. They are backed by a third-party insurance company, not by the manufacturer.
  • Repairs performed under an extended warranty are generally performed by contractors selected by the insurance company. “Many policies do not cover accidents or normal wear and tear — the most common causes of breakdowns on common household goods.”
  • It often costs more for the extended warranty than for common repairs.
  • Few extended warranties are ever used because:
    • the products don’t need repair,
    • it’s a hassle to use one, and
    • consumers forget the policy or misplace the information.

According to the article, $15 billion in premiums was charged to U.S. consumers in 2004, of which $7.5 billion went to the stores who sell the warranties. About $3 billion was paid in claims against plans. Only $20 every $100 spent on extended warranties is paid in claims. By comparison, the American auto insurance industry pays $66 in claims for every $100 in premiums.

Reading the latest issue of Consumer Reports — the annual electronics issue — I noticed that it nearly always recommended purchasing an extended warranty. (The magazine recommends extended warranties on Apple products — which only provide 90 days of support — and “for refurbished computers of any brand with less than a one-year warranty”.) Some experts also recommend extended warranties on bulky LCD or plasma televisions.

Obviously, it’s the consumer’s choice whether or not to purchase an extended warranty. For some, the peace of mind is worth the cost. But most people don’t understand how poor a financial decision an extended warranty usually is.

[The Washington Post: Unwarranted]

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