The truth about extended warranties, and what to do instead

Buy a car, house, or virtually anything expensive, and we usually don't walk out the door without first being hit up for an extended service plan, or warranty. These warranties are sold as a way to protect our investments, but do they really work? A better question: Do we actually use them?

The truth is these extended warranties often do nothing more than serve as a healthy source of commission for your salesperson. Darn near 50% of the cost of warranties are kept by the retailer. The margins are sky high, more or less extra profit for very little risk shouldered by the business. The same is often true for home warranties: an extensive version of extended warranties that covers all appliances in your house and costs more than $600 per year on average.

And think about it - a business exists to make money. By very definition, these extended warranties help the business far more than they help the consumer. They are a product, just like whatever we just bought, and no business offers consumers a product at a loss. For the large majority of us, extended warranties are bad investments, and corporations are well aware of that fact.

The reason is simple - the majority of us never use the coverage that we paid for, as Consumer Reports wrote, calling warranties an "expensive gamble".

"A recent Consumer Reports survey found that 55 percent of owners who purchased an extended warranty hadn’t used it for repairs during the lifetime of the policy, even though the median price paid for the coverage was just over $1,200. And, on average, those who did use it spent hundreds more for the coverage than they saved in repair costs."

For a warranty to be worth it, three things must occur:

1. Something needs to happen (a failure, broken equipment, etc) that is covered
2. Warranties have very specific coverage events and stipulations
3. Warranties have dates where coverage is appropriate
4. We need to actually use the warranty that we paid for during the repairs
5. The cost of the repairs needs to exceed the price that we paid for the warranty

Consumer Reports also said, "Some extended warranties simply duplicate the express warranty coverage you have the manufacturer, which you’re required to use first". Oops!

The fact is that warranties are big business.

Case in point - I made the mistake of buying a brand new Cadillac CTS back in 2010. Several years ago, my manufacturer warranty expired, and to this day, I still get phone calls from third party companies attempting to sell me on a warranty. Nearly four years later, businesses remain steadfastly interested in "protecting my investment" for a hefty fee that they know I probably will never use.

According to Warranty Week, Americans spent nearly $15 billion on automotive warranties in 2013. In the same year, another $7 billion was spent on computer-related warranties and over $5 billion for coverage on electronics. In total, Americans shelled out almost $38 billion for extended warranties and service plans. When I say big business, I really do mean big business.

A quick word about exceptions - Naturally, there are times when extended warranties do come in handy. A Google search will reveal instances where warranties do indeed save consumers money. I get it, it happens. Hell, a Harvard Business Review post attacks the Consumer Reports survey by citing intangible benefits of warranties, like the peace of mind we may get by the warranty's protection. The author also provides a story about when his laptop suddenly stopped working shortly after purchase, making the repair costs nil.

But the data on this subject makes the author's argument entirely unconvincing on the whole.

On average, the majority of us will demonstrably lose money on this proposition nearly every time, which accounts for why most businesses hard-sell warranties and extended service plans. They understand that most of us simply won't use them. After all, there's a reason why companies pay call centers to sell consumers on warranties, even well after the purchase. For the business, on average, it's a bet against the consumer that they usually win.

But what about those times when things do go wrong and we wished that we bought an extended warranty? How do we hedge our bets against these kinds of expenses, but minimize spending money on something that we probably will never use? After all, things do happen. Stuff breaks.

If we don't shell out for extended warranties, what do we do then?

A better approach for extended warranties

Instead of buying warranties, consider setting money aside - perhaps in an interest-bearing savings account, to provide resources for any unforeseen expenses related to our more expensive purchases - in essence, setting up our own warranty coverage. This way, WE have full control over this money and can re-purpose those funds, as necessary, if we sell the item without needing to use this money.

According to the numbers, this strategy will work in your favor much more than it won't. Essentially, we are betting that we'll spend less money in the long run compared with buying a warranty, and I'd take these odds in Vegas any day of the week.

How much should we set aside? Consider setting aside about half of the cost of the item that you bought.  If you bought a $600 cell phone (ugh!) and were hard-sold on a $100 warranty, then put $300 aside. Or, if an extended warranty for your car costs around $1850, then put $925 aside in a savings account (half the warranty amount in this case). Your money will grow (albeit slowly), and chances are you'll never use it.

And even if we do need to use the money, we also aren't filling out any paperwork, submitting receipts and waiting for weeks for reimbursement, or fighting with the company over something that we thought was covered but wasn't. A headache and a half - every time.

By the way, your emergency fund can work the same way depending on how liberally you interpret an "emergency" in your life to be. Keep your own warranty coverage in an easily-accessible account that you control rather than depending on a for-profit company, who depends on you to NOT use your warranty coverage, to protect your stuff for you.

Because in the end, the company will protect itself first and you second.

And that's something you can bet on!

MONEY SAVING TIP: Credit cards often provide warranties on the things that you buy with that card. Investigate your credit card's perks to avoid purchasing redundant warranties even if you believe the warranty is worth the cost.

Three questions to ask before saying yes

If you're considering an extended warranty, ask yourself three questions before signing on the dotted line and forking over more money:

1: How likely is it that this thing to break?

Do a quick Google search about the reputation of whatever you're buying. Or, look it up on Amazon and read the reviews. The better the product is, the less likely you'll use that warranty. Remember that even if something does happen, the manufacturer's warranty is often sufficient and will need to be used before your extended warranty applies.

2: Would depreciation make buying a new one worth it?

If you're buying a $250 cell phone, chances are that the cost of a similar phone will be around the same price, or even cheaper, in two years (a common extended warranty lifespan). That $50 extended warranty might not be worth the value in this case, especially if you put half the item's value aside.

3: Do I know exactly what is covered?

If something does happen, do you know exactly what the warranty will cover? Under what circumstances would the warranty NOT apply?

Frequently Asked Questions:

What are extended warranties?

Extended warranties are optional plans offered during the purchase of goods like electronics or vehicles, extending the warranty period provided by the manufacturer. They're designed to cover repair costs that might occur after the standard warranty period has expired.

Are extended warranties cost-effective?

In most cases, extended warranties are not cost-effective. Consumer Reports found that 55% of people who purchased extended warranties didn't use them within the policy's lifespan. Additionally, the cost of the warranty often exceeds any savings from repairs.

Why do businesses push extended warranties?

Businesses promote extended warranties because they are highly profitable. Approximately 50% of the warranty's cost is retained as profit by retailers, providing them a substantial revenue stream with minimal risk.

What should I consider before buying an extended warranty?

Before purchasing an extended warranty, consider the reliability of the product, whether the manufacturer's warranty is sufficient, and the cost of the warranty relative to the potential repair costs. Assess whether the peace of mind it offers is worth the price, given the likelihood of needing repairs.

What are some alternatives to purchasing an extended warranty?

Instead of buying an extended warranty, consider setting aside money in a savings account to cover potential repairs. This self-insurance method ensures you retain control over the funds and avoid unnecessary expenses on underutilized warranties. Also, check if your credit card offers extended warranty protection as a perk, which can provide similar coverage at no additional cost.