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For a change in pace from all the politics, I thought I’d offer a little consumer advice as we head into the Christmas shopping season. To wit, buying an extended warranty is almost always a bad idea.
To explain why, let me show you a graph of the typical life-cycle of a manufactured product. In engineering we call this a ‘bathtub curve’ because of its resemblance to the shape of a bathtub:
Allow me to explain. Any product goes through three phases of reliability in its lifespan. First is the “infant mortality” phase, denoted by the green box above. This is the time when products fail due to manufacturing errors, design errors, materials issues, etc.
The second phase is the normal life of the product; i.e, once the early failures have left the market, what remains tends to work properly for the rest of its design life, with very low overall failures. That’s the white section in the graph.
Finally — as a product reaches the end of its design life — it begins to wear out. Things start to fail because of normal wear and tear. That’s denoted by the blue area in the graph.
Now, a manufacturer’s warranty protects you from the infant mortality phase. If parts on your car or toaster fail here, it’s because something was built wrong, and the warranty covers you in that case. And protecting you from manufacturing flaws is precisely what a warranty should do.
An extended warranty applies to the “middle” phase, and is timed to end before normal wear and tear starts causing failures.
Manufacturers of products have the data that allows them to predict these phases. They know where the period of high reliability starts and ends. You, on the other hand, do not. Magazines like Consumer Reports or independent research like JD Power reports may give you good information about the early failure rates, but they aren’t going to be able to tell you when the thing you are buying will begin to wear out.
What this means is that the manufacturer in this case has an advantage over the consumer: a classic example of an information asymmetry. That allows them to offer a “warranty” at relatively high cost that protects you from product failure during the period the product is least likely to fail. And since you have no idea how likely that is but they do, they can use that information to price the extended warranty such that a healthy profit for them is baked in.
In a complex product like a car, there are many “bathtub curves.” Each sub-assembly may have different failure patterns. So, when you look at an automotive extended warranty, you’ll usually find that certain things aren’t covered, sometimes inexplicably. The engine may be covered, but not the alternator. The transmission may be covered, but not the torque converter. Why? Because the extended warranty is optimized to maximize profit for the auto dealer, and sometimes that means leaving things out that are likely going to be too expensive to fix because they are most likely to fail during the extended warranty period, or because their lifespan is too dependent on variables like driving habits or road conditions to be predicted with enough accuracy to work into the formula.
In fact, it can be worth looking at the extended warranty when considering the purchase of a car not because you want to buy the warranty, but because looking at the list of excluded items can tell you a lot about what the car company expects will fail first on the car. That can help inform your knowledge of the vehicle’s overall reliability.
Other Reasons to Avoid Extended Warranties
This advice about avoiding extended warranties doesn’t just apply to vehicles, but to all consumer products. I won’t go so far as to call them a scam, but they are usually a very high profit item for the seller, and therefore very poor value for the consumer. Here are some other reasons why:
- You may forget about it. If you have a habit of buying extended warranties, how do you know that the product that just failed is covered by one? Do you remember which of your goods is covered by warranty and which are not? Do you have all the paperwork? Did you think to check for it before tossing the thing in the trash? The statistics show that many extended warranties are never claimed, even when they are valid. That’s pure profit for the seller.
- You may replace the product before the warranty is out. A five year extended warranty on a laptop is useless if you tend to replace it after two or three years. Or, you may break the product in a way that invalidates the extended warranty anyway. Every car wrecked during its initial warranty period is a car that will never claim extended warranty coverage, coverage that might have cost thousands of dollars.
- The warranty may be invalid. Some items have very specific conditions for a valid warranty claim. They may require you to have a copy of the contract and the invoice for the product. They may inspect the product and decide it wasn’t used correctly. The specific failure may not be covered by the warranty. There are many reason why an extended warranty may not be claimed.
- The warranty isn’t transferable. Many extended warranties cannot be transferred. So, if you sell the item covered, that value is lost. And even if it is transferable, is the new owner going to know that? Is he or she going to care? Can you extract value from that warranty by charging a higher price? Almost certainly not.
- The warranty costs you now, but has no value until the factory warranty runs out. Think about that one: if your car has a 5 year warranty, and you pay up front for a 5 year extended warranty, the car company gets the use of your money for five years before it has to worry about possibly paying it back. If you could have earned 5% per year on that money, the warranty cost you 28% more than the up-front price.
There are other reasons to avoid extended warranties, but these are the big ones. In general, an extended warranty violates the principle that you should never pay for insurance when you have the finances to self-insure. Insurance is always a negative-expectation bet, with the insurance company selling you risk mitigation at a cost. It’s never a good deal, but may be necessary if you can’t bear the risk. In the case of most consumer goods, that’s not true for most people.
A Good Alternative Strategy
Here’s a good strategy for managing risk while saving money: set up a savings account called “product insurance.” Every time you are offered an extended warranty, refuse it and put an amount equivalent to the cost of the warranty into that savings account.
When a product you own fails outside of the normal warranty but within the extended warranty period, replace it with money from that fund. You’ll almost certainly find that the account grows in size over the years, and perhaps very substantially. Every dollar in that account is a dollar that did not go to line the pockets of the salesman and the company that sold you the product.