Family Finance Blog

When you shop at a place like Circuit City or Best Buy and buy an electronic gizmo, when you get to the register you’ll be asked a question like “Would you like to buy the three year extended warranty for this gizmo? It will only cost $49.99 and will cover you for three years for any problems with the equipment.” Then you sit there for a few seconds and consider to yourself, “well, it is only $49.99 and I wouldn’t want to have to buy this $600 gizmo again in case it breaks, so it sounds like it’s not such a bad idea.”

Here is an interesting quote I found from a Business Week article about extended warranties:

Last year, profits from warranties accounted for all of Circuit City’s operating income and almost half of Best Buy’s, say analysts. They figure that profit margins on contracts are between 50% and 60%. That’s nearly 18 times the margin on the goods themselves. For example, a four-year contract on a $3,000 flat-panel TV costs about $400.

Read that again. Circuit City, in 2003, earned all of their profit from extended warranties, and Best Buy half of their profits. That’s ridiculous. By the time you account for shelf space, employee time, rent, utilities, etc., these stores are not making a whole lot of money on the gizmo that you buy. However, when you add the extended warranty, they are making a ton of money, and it is pure profit.

Most items that are going to fail dramatically will fail from a manufacturing defect that will occur within the first 90 days of ownership, when the regular warranty still applies (and the manufacturer pays for the repairs, not Circuit City). It is very infrequently that an item breaks during the extended warranty period, and so Circuit City (or whoever) doesn’t spend much of their profit having to fix broken items. Sometimes they will even give you incredible-sounding 10 year warranties, relying on the fact that by the time the item is 5 years old, you’ll want a new one anyway, or you’ll have lost the receipt or forgotten about the fact that you had the warranty in the first place.

There are times when buying an extended warranty is worth it. Extended warranties are a type of insurance. You buy insurance when you cannot afford the consequences of the item breaking. For example, I cannot afford to pay someone’s $100,000 medical bills if I am at fault in an auto accident with them, so I have car insurance. However, I can afford to replace my $400 refrigerator if it breaks, so I did not purchase the extended warranty for it.

In order to determine whether or not the extended warranty is worth it, consider two primary questions:

• How long would it take you to have enough money to buy a new item (PS, this is where an emergency fund comes in handy so you already have the money on hand)?
• What would happen to your household if you did not have that item for that period of time?

If it would take you three months to save up another $350 to buy a washing machine for your house and your six children, then it might be appropriate to buy an extended warranty when you buy your washing machine. But if the answer to the first question is “not very long” or the answer to the second question is “not all that much”, then you certainly should not be buying the extended warranty.

But sometimes the extended warranty is worth it, you say? There was a time when you had an item break and thank goodness you had bought the extended warranty? Well, that means you were lucky. Most people won’t ever be able to say that they used their extended warranty. From my experience, the average extended warranty costs about 10-25% of the cost of the item (for example, an iPod Nano costs $150, and the extended warranty costs $40, which is actually 27%.) So if we say that it averages about 20% of the cost of the item, that means that 1 out of every 5 items you buy needs to break in the extended warranty period for the warranty to be worth it. This is hard to do. It means that the device can’t break in the normal 1 year warranty period (which you get for free), but has to break before the 3 year extended warranty period. That is just not going to happen 1 in 5 times.

Now, there might be the 1 in 20 times that you do have something that breaks in your extended warranty period, and you didn’t buy the extended warranty. And you’ll kick yourself for the next few weeks because you didn’t buy it because that guy on the stupid financial blog told you not to. But in the long run, you’ll be much further ahead if you don’t buy them. You can take that extra money and do something useful with it, like put it away in your emergency fund to cover the times when one of the things you bought does break. Keep the profit for yourself instead of for Circuit City.

This entry was posted on Friday, July 27th, 2007 at 8:53 am and is filed under Frugal living, Emergency Fund, Money Saving. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.