Don’t ever buy them. Ever.
Each year, millions of people gladly pay an additional 10 to 50 percent of a product’s original price to extend a warranty. These snap purchases help fuel a booming, $15 billion-a-year business and feed a lucrative profit stream for retailers that sell the warranties and companies that underwrite them. Many consumers do so because they say the plans provide them with peace of mind.
The decision to buy an extended warranty defies the recommendations of economists, consumer advocates and product quality experts, who all warn that the plans rarely benefit consumers and are nearly always a waste of money.
“The things make no rational sense,” Harvard economist David Cutler said. “The implied probability that [a product] will break has to be substantially greater than the risk that you can’t afford to fix it or replace it. If you’re buying a $400 item, for the overwhelming number of consumers that level of spending is not a risk you need to insure under any circumstances.”
Now, I’m as guilty as the next consumer, and I just invested in an extended warranty for my iPOD. Why? Behavioral economics provides us with a nifty explanation, called mental accounting. Richard Thaler was the first economist to document this irrational phenomenon. When he asked people whether they would drive 20 minutes out of their way to save $5 on a $15 calculator, 68 percent of respondents said yes. However, when he asked the same people whether they would drive 20 minutes out of their way to save $5 on a $125 leather jacket, only 29 percent said they would. According to Thaler, this discrepancy demonstrates that our decision about whether or not drive 20 minutes depends less on the absolute amount of money involved ($5), than on the mental account in which the decision occurs. How does mental accounting relate to consumer warranties? Well, after just spending a few hundred dollars on a new HDTV, or washing machine, or iPOD, spending a few more dollars on an extended warranty doesn’t seem like a big deal. Because the warranty is only a small part of a much bigger purchase, we end up paying for a frivolous option that we would never purchase otherwise. Retail stores have learned to take advantage of this mental accounting heuristic, and it’s estimated that up to 50 percent of profits at the big electronic retailers (like Circuit City) come from extended warranty sales.
PS. Another possible explanation for the plethora of extended warranties is loss aversion. I know that when I saw my beautiful new nano iPOD, I cringed at the thought of it being broken, and was all too happy to spend $40 to avoid that outcome.