Extended warranties, by offering protection for expensive purchases and increasing the length of a product's original warranty, have become the norm for many retailers. These warranties often appeal to thrifty consumers, for whom buying big-ticket items like appliances and electronics can be an exacting decision.

When you're pulling out your wallet to pay for that new refrigerator, big-screen TV or treadmill for your home gym, it's hard not to be tempted to buy into the extended warranty sales pitch - even if it will increase the cost of your purchase by hundreds of dollars. But are these warranties worth the price? We'll show you why in most cases, the benefits of these warranties don't extend beyond the profit margins of the companies that offer them. (To read more about risk and warranties, see Using Logic To Examine Risk.)

An Extended Warranty Is Insurance
An extended warranty works like an insurance contract for the product you purchase and can be offered by either the product's manufacturer, or by the retailer, which contracts this service out to an insurance company.

What most consumers fail to realize is that although the price of an extended warranty often seems like a bargain to a consumer who is aware of the steep price of repairs, it has actually been carefully considered through actuarial analysis by the company that offers it. In other words, the company uses probability and statistical methods to calculate the likelihood that your new refrigerator or big-screen television, for example, will require repairs. This figure is weighed against how much those repairs would cost to arrive at the price that a company will charge consumers for a warranty on a particular item. This formula is not designed to work in your favor.(To find out what other policies you can avoid, see Fifteen Insurance Policies You Don't Need.)

Probabilities and Profit Margins
Extended warranties, like the products they claim to protect, are sold to consumers for a profit and can be big money-makers for retailers. According to "The Warranty Windfall" (BusinessWeek, 2004), profits from warranties accounted for all of CircuitCity's 2003 operating income. In fact, the operating profit margins on extended warranties can be as high as 70%, compared to only 10% for the products they cover, according to a December 2003 article in Consumer Reports. (To find out how to read companies' financials yourself, see What You Need To Know About Financial Statements, Footnotes: Start Reading The Fine Print and Common Clues Of Financial Statement Manipulation.)

What this means is that for every dollar you spend on an extended warranty from a retailer, $0.70 goes to the retailer, with the remaining $0.30 going 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. In fact, when Consumer Reports conducted a survey of 38,000 consumers in 2000, it found that only 8% of camcorders, stove ranges, dishwashers and refrigerators were repaired within the first three years of when they were purchased. Because these warranties cost almost nothing to market and often go uncollected, 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 - it 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 your new appliance would add up fast if you have to pay for them yourself and could easily exceed $660 if something goes wrong.

Figure 1: Consumer report repair rate

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.

Let's return to our example with the washer and dryer set. In a best-case scenario, you would purchase your appliances, 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 yourself $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 that those repairs cost more than the $660 warranty you could have purchased.

However, according to the statistics from the Consumer Reports study shown in Figure 1, your washing machine has a 22% chance of needing repairs within the first three years, and your 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? Better yet, instead of handing your money over to the retailer, could put the $660 aside in case your new purchase requires repairs down the road. This way, not only will you get to collect interest on your own money, but you'll also get to keep it if you beat out the odds and your appliances keep running as they should.

The Flip Side of Warranties
Manufacturers and retailers tend to push warranties because they're profitable, but 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. Also keep in mind 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. This should be enough to cover you if your product turns out to be defective. Furthermore, if you buy an extended warranty on top of this initial warranty, it will also start immediately, forcing you to pay a second time for coverage you already have.

Also consider the replacement cost of the product you are buying, particularly when it comes to electronics. As these goods continue to improve and the prices continue to drop, your warranty could easily end up costing more than it would 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 yourself. In many cases, the odds will be in your favor and your best course of action will be to bet that your appliances and electronics will outlast the warranties you left behind.

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