Extended Warranties Are They Worth It – New cars come with warranties. These warranties cover specified repairs for a certain period of time or mileage range. Although these warranties are reassuring and helpful, you may consider an extended warranty. To find out if extended warranties are worth it and for help choosing one, keep reading.

An extended warranty is a contract between a vehicle owner and a third party to cover the cost of certain repairs and mechanical malfunctions after the factory warranty expires. The goal of an extended warranty is to cover potential repairs and mechanical issues that may not be included in the standard warranty. This may be attractive to car buyers because it can potentially save them money.

Extended Warranties Are They Worth It

Extended Warranties Are They Worth It

There are three types of extended warranties. These types are service contracts, manufacturer extended warranties, and aftermarket extended warranties. A service contract is an agreement between the repair center and the vehicle owner. The repair center creates an agreement that it will provide repairs to the vehicle within a certain time frame or mileage range outside of the manufacturer’s warranty and the vehicle buyer agrees to these terms and pays the agreed upon amount.

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The second type of warranty is the extended manufacturer’s warranty, which is offered on new cars by the car dealership that sells them. With this type of extended warranty, the dealer offers an extension to the new car’s warranty. It usually covers the same things as a regular warranty, just for a longer period of time.

The last type of warranty is an extended aftermarket warranty. This type of warranty shares some similarities with extended manufacturer warranties, but coverage is not always comprehensive. It may only cover some of the things covered by the manufacturer’s warranty or it may only cover major mechanical breakdowns.

While all three of these guarantees offer some benefits, one may be better suited to you than another. Depending on your needs and interests, you can determine which type of warranty is most suitable for you.

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About 15 years ago, Yuval Salant bought a laptop from a major electronics store. The seller offered him an extended warranty to cover any repairs needed after the manufacturer’s warranty expires.

Salant decided to buy the security. “Why don’t we just have a safety net?” He thought. But when he returned home, he wondered if he had made the right decision. He consulted his cousin, who worked in technology, who told Salant that laptops rarely broke. “I realized that the guarantee didn’t actually make sense,” says Salant, now an associate professor of managerial economics and decision sciences at Kellogg University. (He later returned the warranty.)

Salant isn’t the only one who has doubts about the extended warranty market. Their high prices and huge profit margins for retailers — sometimes around 50 to 60 percent, according to Bloomberg Businessweek — have also drawn suspicion from government authorities. They “realize that something doesn’t make sense,” he says.

Extended Warranties Are They Worth It

Salant wanted to know why so many people buy extended warranties despite such high prices, which are often about a quarter of the cost of the product itself. Several possible explanations came to mind. Are consumers willing to pay large amounts to avoid risks? Does the fact that retailers face little competition when selling extended warranties give them unrestricted ability to influence consumer behavior? Or are customers simply overestimating the product’s failure rate?

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A new study by Salant and José Miguel Abito of the University of Pennsylvania suggests it’s the latter reason: People believe a product is much more likely to break than it actually is.

Researchers have also found a way to reduce this irrational behavior. If consumers were told the failure rate of the product they were purchasing, they would be willing to pay much less for the warranty.

The results suggest how policy makers can better regulate the market. Some experts have recommended encouraging more competition to help drive down prices, which means the average customer will lose less money on unused warranty. But this strategy “will be less effective than one might think,” Salant says, and may even backfire.

When it comes to warranties, Salant explains, retailers have so much “market power” — meaning there’s little competition — that consumers typically don’t get to choose between multiple warranty providers in a store.

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“It’s like when you go to the movies, you pay a lot for popcorn and drinks. That’s because you’re already captive,” he says.

The US and UK governments have tried to help consumers make better decisions about warranties. The US Federal Trade Commission advises people to consider the potential for product failure and the cost of repairs, for example. Meanwhile, the UK Competition Commission has proposed requiring electronics retailers to publish their warranty prices alongside the price of the insured product in-store and in advertising, allowing consumers to better compare warranty prices between stores, which could lead to lower prices.

But to know whether these strategies will work, researchers first need to know what drives consumers’ enthusiasm for extended warranties: is it risk aversion, or is it a distorted sense of how often products fail (or might fail for them)?

Extended Warranties Are They Worth It

To find out why warranties are so common, Salant and José Miguel Abito of the University of Pennsylvania analyzed about 45,000 transactions at a major electronics retailer from 1998 to 2004. The data set, provided by the Institute for Operations Research and Management Sciences, includes information about prices, returns and buyer demographics.

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Among all electronic devices, an extended warranty costs 24 percent of the product price on average. Clients bought warranties 20 to 40 percent of the time.

They obtained TV failure rates from Consumer Reports, found that TVs broke 5 to 8 percent of the time during this period, and used those rates to conclude that profit margins could be as high as 62 to 73 percent.

The team then developed a mathematical model of the security market. In the model, retailers choose warranty prices to maximize profits, and consumers decide to purchase the warranty based on the price and their assessment of the probability of failure. The researchers used their model and data to determine whether consumers were simply risk averse, or whether they were somehow distorting the likelihood of their products failing.

The model explained that the latter explanation was the culprit. “Risk aversion is negligible,” Salant says. “It’s not really what affects people.”

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Customers were distorting failure rates by a large margin. For example, when the actual failure rate of a product was 5 percent, people acted as if it was 13 percent.

Was this consumer behavior happening because people didn’t know the true failure rates? Or did they recognize them but, in the decision-making process, gave too much importance to the possibility of unexpected failure?

To find out, Salant and Abito ran an online experiment with about 1,000 participants. Participants were asked to imagine that they were buying a television. Some were told that an expert believes the probability of a TV being damaged within the next three years is 5% (the average found in a Consumer Reports survey of popular TVs). Other participants did not receive this information and instead provided their own estimates of the failure rate. All participants were asked how much they would be willing to pay for an extended warranty.

Extended Warranties Are They Worth It

People who did not receive an expert assessment significantly overestimated the likelihood of needing repairs. Their average forecast was 13 to 15 percent, and they were willing to pay an average of $50 for the guarantee.

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This demonstrated that customers were buying warranties because they were not aware of the actual probabilities of failure. “The willingness to pay drops dramatically if they get the information,” Salant says.

Finally, the team used their model to predict how three different policy solutions would play out: better informing consumers, introducing more competition among warranty providers, or doing both.

In the scenario in which consumers were simply exposed to accurate failure rates, leaving all other market conditions the same, consumers bought fewer warranties. Warranty profits fell by more than 90% in this simulation, even though retailers still had little competition and had the market power to set high prices. “It’s not market power that drives profit,” Salant says. “It’s volume that drives profit.”

In another scenario, researchers looked at what would happen if customers could compare prices for extended warranties across retailers, but were unaware of product failure rates. In this case, consumers fared worse than they do today. This is because increased competition would lower prices, tempting more people to do so

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