Written by: Kyle Thompson, CFP®, CPA
If you have purchased a big-ticket item you have likely been asked the question, “Would you like to purchase an extended warranty for ONLY “x” dollars?” These warranties are almost always offered on car and home purchases but are also becoming commonplace on appliances, electronics, and tools.
We like to have peace of mind on the goods we are purchasing, but are the extended warranties worth your hard-earned dollars? Consumer Reports (CR) has written several articles on this topic and they claim that extended warranties often do nothing more than serve as a healthy source of commission for your salesperson. CR claims that nearly 50% of the cost of warranties are kept by the retailer. These margins are very high and help to explain why they get pushed aggressively on consumers. Extended warranties have become a multibillion-dollar business for both the retailers and warranty companies and often a source of frustration for the consumer.
The Math Behind Extended Warranties
I have always been against extended warranties after a negative personal experience (see below) but I was floored when I started researching the topic and began understanding the statistics behind the warranty premium. If you purchase an extended warranty on a car for $1,500 only 12% of this premium is applied towards a claim payout.
Let me repeat that again…only 12% of your hard-earned money is going towards a potential claim payout.
In other words, the statistical probability that a claim will be paid against all the covered autos is only 12% during the extended warranty period. The remaining 88% goes towards overhead, commissions, and profits for the dealership and warranty company. If we convert the percentage to dollars you can expect an average repair bill during the extended warranty period to be around $180. The remaining $1,320 that you paid for the warranty was for the dealership and warranty company to enjoy. To make matters worse, many consumers end up financing these extended warranty premiums into their auto loan. This means that they are also paying interest on top of the warranty cost.
I know you have all heard that one story where the warranty saved the day and covered a $3,000 repair. While this can happen, it is not the norm and, statistically speaking, the chances of this happening are very slim. Warranties are very much like Vegas. There is always a chance you can win, but it is guaranteed that the house or in this case, the warranty company, will win in the end.
My Personal Warranty Experience
We bought our first home in 2007. As part of the purchase price they stuffed in a home warranty. At the time, I thought this was great. We were young and just getting started and I really didn’t know about the warranty business. Fast forward 8 months from closing and we are now and in the middle of winter and our furnace quit working. At the time I thought, “That’s great! I have a warranty which will cover everything and maybe we will get a new furnace out of the deal.” Oh, how naïve I was!
I called the warranty company (this falls somewhere between talking on the phone with your local cable company and having a root canal). I explained the situation and asked what steps were needed to file this under our home warranty. They informed me that I would have to call one of their approved heating and air vendors. Yes, you are forced to use their vendors as opposed to choosing who you would like to work with. Not great, but not a deal breaker.
About two days later a technician showed up in an unmarked van. It quickly became evident that he was a one-man band. I am not an expert in heating and cooling, but I don’t believe he would be your first choice. Nonetheless, he tore into the furnace and determined that the heat exchanger was cracked. He was forced to shut off our gas so now we were out of heat and hot water. He then proceeded to tell me that he would need to submit his findings to the warranty company and that they would contact me in 1-2 days.
We had gone a week with no heat, and it was obvious that the repairman was not going to fix the problem on this trip. I pushed him and asked what his recommendation would be if we were paying out of pocket. He essentially said that a cracked heat exchanger is a very expensive repair and most of the time with a furnace nearing the end of its life, such as mine, it is always best to replace the unit.
Once the warranty company received the report, they had to send it over to their claims department for review. Another 2 days. Finally, on day 10 or 11 (who is counting at this point?) we received word that they wanted a second opinion, so they sent out another company who provided the same diagnosis.
At this point my blood was boiling (the irony, right?). Another two days passed, and the warranty company finally determined that they would pay to have the heat exchanger replaced but would not replace the unit. In the meantime, we had called a local heating and air company of our own choosing to get their opinion as we had been less than impressed with the two businesses our warranty company provided. We were also losing faith that the problem was going to get fixed. The company that we chose for a second opinion strongly recommend that we replace the entire unit as the coil beneath the unit was also failing.
The Moral of the Story
If you choose to purchase an extended warranty do you research and remember “caveat emptor” - buyer beware.
In the end, we opted to have the unit replaced and paid the majority of the cost out of pocket. Our consolation prize was a small payment from the warranty company based on their projected cost of the part. Labor was not included since we used our own contractor.
What To Do Instead
Instead of spending your hard-earned money on an extended warranty that’s likely not going to do you any good, I would recommend that you setup your own account where you set aside money each month for future repairs. If you don’t end up having any repairs (remember only 12% will), then you can apply this money towards a future replacement.