When an extended warranty makes sense

They’re generally a pretty bad deal

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extended warranty

(Henrik Sorensen / Getty Images)

While shopping last weekend, I was twice offered the “opportunity” to buy an extended warranty on a consumer good. Both times I declined. In one case, I bit my tongue because the warranty was such a bad deal that I was tempted to chastise the salesman. But in neither case do I think it wrong for the sellers to try to sell the warranty to me.

Let me explain.

“Extended” warranty offers are common these days. Such warranties may cover a longer period of time, or cover a greater range of problems than does the basic warranty that comes with the product. Whether you’re buying small electronics or a laptop or major appliances, the salesperson will likely offer you the chance to pay extra to get a warranty that goes above and beyond.

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But let’s focus here on the small stuff—not major appliances, but smaller items. And let’s start with the two warranties I turned down this weekend.

First, I bought a new pair of prescription reading glasses, for $500. The extra warranty I was offered was priced at $25.

Next, I bought a small, waterproof digital camera to take on a beach vacation. Cost: $189. The young salesman (he could have been one of my students) confidently explained that I “really should” buy the extended warranty, for “just $49.”

Now, whether you should buy a warranty depends on two things. First, it depends on the probability that something bad will happen to the product you’ve bought, multiplied by the cost of repair. That gives you the “expected value” of not having the warranty, which is what you must compare to the expected value—the price—of buying the warranty. In most cases, the expected value of the warranty will be lower than the value of going with out it. Not a good deal.

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But one more factor must be counted, namely whether you can afford to cover the cost of loss or damage yourself. If my house burned down, I wouldn’t be able to afford to buy another one, which is why I have house insurance. But in the case of the $189 camera, I know that if it breaks I can afford to pull out my credit card and buy another, and so the ridiculously expensive warranty doesn’t make sense for me. But the warranty could conceivably make sense for someone who has the extra $49 to spend on the warranty, but who absolutely would not be able to afford another $189 for a new camera eighteen months from now. People in that category are presumably relatively few, but not zero.

What direction did my rough math point in, for the two warranties I was offered this weekend? I figured the warranty on the glasses might, barely, be worth it, but I decided to take a risk and opted not to buy. (Besides, I’m in my 40’s and my prescription might well change in the next 2 years, which would mean buying new glasses anyway.) The warranty on the camera, on the other hand, was laughable; I would have been a fool to buy it. (You can find lots of blog entries out there about why extended warranties on small electronics are generally a bad deal.)

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So what about the ethics of offering such crummy warranty deals to customers?

In general, I think it’s ethically fine to offer such warranties, even though they’re generally a bad deal.

First, the dollar value on these things is relatively low. So, although I think the $49 warranty is (for most buyers) a rip off, it’s a small rip off. No one is going to miss a mortgage payment over it.

Second, the ability to figure out whether a warranty is worth it is well within what we should expect in terms of basic financial literacy for grown-ups. That’s not to say that everyone has that bit of financial literacy. But warranties on small electronics are very simple insurance policies. Compare the question of selling indexed annuities or derivatives or other complex investments. In those cases, investment professionals are selling highly sophisticated financial instruments, and we should expect them only to sell them to sophisticated investors.

So buyer beware. There are bad warranties out there. And they’re generally not unethical products, so even an honest salesperson can earnestly advise you to buy a warranty that you don’t really need.

This article was originally published on Canadian Business. 

One comment on “When an extended warranty makes sense

  1. The original novel coatnined extraordinarily blindly optimistic assumptions on rates of return. In fairness, the 80s had seen government bonds with 10%+ returns. Twas the times as they say. Obviously, given all the money being printed, the housing bubble, and the fact that the stock and bond markets have been moving in unison, we are in a very different world than 1989. I’m in the process of reading his latest book; it seems a lot more fitted to the modern world but I’ll save that for the review. I will definitely consider reviewing LEAP sometime; I will put it on my check the library list.RRSPs generate taxable income which is at a higher marginal rate due to OAS clawback as you point out. Do you think however, that given recent adjustments to the OAS system, that it will be available to anybody with a pension upon retirement? Also, is it really wise to rely on, essentially, a welfare program in retirement? I think it’s incumbent on me as a citizen to prepare for retirement. CPP, as you note, is very expensive. I’ve paid craploads into it and I’m not even 25; I can only imagine that you’ve paid in an obscene amount. Obviously you expect it to be there. If they raised the age on CPP I think there’d be a lot of justifiable outrage we’ve contributed to it after all! But OAS is just funded out of government revenue and it’s meant to alleviate poverty (like the GIS but OAS is not only for the truly destitute). Also, if you don’t have a pension and you max out your RRSPs when you’re, say, 25, you’re deferring a *ton* of taxes and tax-free growth until your retirement. I guess I just don’t understand why any alternative is superior to the RRSP for the *average* situation (although as somebody with a defined benefit pension, I can’t contribute much to RRSPs anyway).

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