Whenever I buy something electronic, whether a new smartphone, TV, laptop or whatever, I typically receive a hard pitch to buy an extended warranty on the product. I generally opt not to, but is that the right choice? To answer that question, there is both an economic and a psychological way to look at it.
Economics of an extended warranty
An extended warranty is essentially an insurance policy. If the item fails beyond the basic warranty — typically one month to one year, depending on the product — the company you bought the warranty from promises to either fix or replace the product during a term set forth in the extended warranty.
In general with insurance, keep in mind that insurance companies expect to pay out less in claims than the amount of premiums they charge. For that reason, I only insure for what I can’t afford to lose and will select the highest deductibles available. In effect, I’m self-insuring the deductibles. Sure, if I wreck my car, I may wish I had a low deductible, but I know the odds and know it won’t cause a hardship with my family.
The same can be said for avoiding the extended warranty, though the logic is far more compelling. In fact, according to Bloomberg Business, extended warranties are a windfall for the seller. The cost to companies for providing these warranties is likely quite low, which translates to the consumer receiving an economic benefit that is also quite low.
Here’s an analysis from the consumer’s viewpoint. I looked at a $600 laptop from a major retailer that offered extended warranties. The laptop came with a one-year warranty, but I could buy two additional years for $170. The maximum benefit I could have from the purchase would be $430 — the difference between the $600 cost of the laptop and the $170 warranty.
The economics are decisively clear that I should turn it down. If the product failed one year and one day after purchase and I needed to replace it, I could probably do so for less than $400, since the prior years’ models of all electronics typically are heavily discounted as the technology changes so quickly. Thus, I’d be out only $230.
Beyond that, many credit cards will extend your warranty for anything purchased with that card. My credit card, for instance, would cover the second year.
In this example, I could also have purchased the warranty with accidental breakage insurance, which neither the manufacturer’s warranty nor the credit card would cover. So I might benefit if I broke the device right after the purchase.
Psychological benefits of an extended warranty
Again, although I wouldn’t buy this extended warranty, it doesn’t mean you shouldn’t. We humans have a psychological aversion to loss. In fact, research indicates that we feel twice as much pain from a loss as we feel pleasure from a gain. This loss aversion research was conducted by Daniel Kahneman of Princeton University, for which he won a Nobel Prize. So the pleasure and peace of mind from not needing to fear the loss could make a warranty worthwhile for you. That is to say, the pleasure of not having to worry about dropping the computer on day one, combined with the possible regret of the actual loss, may be worth the $220 expenditure.
Admittedly, when I’m in a store and hear a customer succumbing to the pressure of the salesperson to buy an extended warranty, I do engage in a rather arrogant inner monologue. There are times I even consider intervening and telling the customer that these warranties are more about profit for the store than protection for the consumer. I keep quiet, of course, as even I have some tact. After all, it is just another product to be sold by somebody whose job it is to sell it. It’s up to the buyer to beware and, as in investing, to control irrational psychological urges.
I generally recommend against paying for these warranties.
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