Everyone has a friend who tells them never to buy such warranties, and we all know someone who always buys them. I should say right up front that you simply can't make blanket statements about extended warranties. Sometimes they're a bad idea, and sometimes they're a great idea. Which is the case differs for every person and every product, and even then there are always pesky caveats. The prudent approach is for each individual to analyze his or her own situation to figure out to which category of consumers they belong for each product they purchase. Hopefully, this article will provide you some info, and an analytic framework, with which you can make the best decision on each purchase.
Side note: Before I talk about extended warranties themselves, I want to address one of the most commonly used arguments against them: "Stores/companies make a lot of money off extended warranties, so they must be a bad deal." To some extent, this is true: consumers should be wary of extended warranties in general. Companies wouldn't offer them if they didn't generate profits, and retail establishments often prey on naive consumers who don't know how to evaluate whether or not they should purchase such a warranty.But that's a "macro" problem -- companies make those profits because people who shouldn't buy extended warranties do anyway. That doesn't mean such warranties are a bad idea across the board. An unscrupulous insurance salesman in North Dakota who sells a naive homeowner earthquake insurance when they don't even have earthquakes in N.D. does not make earthquake insurance a bad idea everywhere. By the same reasoning, an unscrupulous, CompUSA salesman who sells a naive computer buyer an extended warranty he/she doesn't need does not make an extended warranty on a computer a bad idea everywhere. Whether or not extended warranties are a profit-making venture for Apple, CompUSA, etc. should not be part of an individual's analysis of whether or not he or she should buy an extended warranty for a particular product.
So let's get back to the topic at hand. The first thing to understand about extended warranties is that they are, in fact, simply a form of insurance, just like car insurance, home insurance, and life insurance. The difference is that instead of paying money just in case you get into an accident, your home is burglarized, or someone dies unexpectedly, with extended warranties you pay just in case something breaks or stops working.
Now that I've got you thinking in terms of insurance, here are the three things you need to consider when deciding whether or not to purchase an extended warranty:
What type of person are you?
Which of these two statements comes closest to describing you?
If you're the former, in the world of economics you're considered "risk-averse." You don't like the risk of not being to afford the worst-case scenario, and will pay (sometimes a lot) in order to avoid being in that situation. The second type of person is often called "risk-loving" (more because they are the opposite of risk-averse than because they happen to love risk itself). These people will rarely pay to avoid risk, and, in fact, risk simply doesn't bother them. In between is the person economists love to call "risk-neutral." When buying insurance, a risk-neutral person looks at the various costs, the probabilities of paying each of those costs, and comes up with an expected outcome or value. They won't pay more than that expected value for insurance, and paying anything less than that value is a bargain.
Of course, few people fall exactly on one of these three points on the risk scale. But these three theoretical consumers are useful for framing discussion of many economic issues.
Why am I wasting your time talking about all this theoretical mumbo-jumbo? Because before making a decision on purchasing an extended warranty, it's important to understand that warranty's actual value, and that value depends in large part on the type of person you are. At the most risk-neutral level of economic analysis, the value of an extended warranty would equal the average cost of a repair, multiplied by the chance that you would need that repair. Let's consider the case of a laptop computer. If 20% of a certain laptop model will require a repair in the 2nd year of ownership, and the average cost of a repair in that 2nd year is expected to be around $200, then the expected value of an extended warranty for that 2nd year of ownership is $40 (I'm making these figures up, by the way). From a purely risk-neutral point of view, paying anything substantially more than $40 for that year is foolish, while an extended warranty that costs $30 would be a pretty good deal. A warranty that costs about $40 would be a toss-up.
In fact, the above analysis is exactly what companies do to figure out how much to charge for warranties. They investigate the repair histories and expected repair costs of each product, and then tack on a profit margin. So in general, the consumer is going to pay more than the "toss-up" price for a warranty. From a purely risk-neutral perspective, this would make all extended warranties a "bad" buy.
However, as noted, few people are truly risk-neutral -- nor should they be. Individuals who are less averse to risk aren't as afraid of being in that 20% who will need repairs. They're willing to take the risk of being in the 80% of people that won't need the repair, and are willing to pay the full $200 (or more, or less) if they are unlucky. Maybe they have lots of consumer products and they figure that, in aggregate, they'll come out ahead by not purchasing any extended warranties and just paying to fix those that break; or maybe they just have a decent amount of fluid capital (read: cash) and can easily afford repairs should they be needed. For these people, extended warranties are less appealing, especially when the company's profit margin is tacked on.
On the other hand, there are individuals who are much more risk-averse. Consider this: unlike the company offering the warranty (who actually pays for all the repairs under warranty, so the average repair cost really is the average repair cost), an individual consumer will only pay the cost of their own repair. Risk-averse people worry that while the average repair for a laptop may be $200, there are also repairs that will cost >$1000. They understand that the odds against needing a repair are in their favor, but they know that if they happen to be very unlucky and end up being one of those that needs a $1000 repair, they couldn't afford it. So for them, an extended warranty ensures that their laptop doesn't end up being a piece of plastic on a shelf that they can't afford to repair should the need arise.
In addition to this value, an extended warranty also provides risk-averse consumers with the peace of mind of not having to worry about their ability to pay for such a repair. While not easily determined, such peace of mind does have value.
So now that you've heard that long-winded discussion on "types of people," you need to decide which type you are, because that will help you decide if an extended warranty is something you even want to consider. If not, stop reading here; if so, then there are two more things you need to consider.
What type of product are you buying?
I made up the figures in the above example (likelihood of repair, average cost of repair), but such figures are actually very important. In addition to your risk aversion and financial status, the failure/repair rate and the costs of repairs should also be taken into account. Products that have rock-solid non-failure rates (products with no moving parts, products built for rugged use) might not benefit from an extended warranty, whereas some products (certain portable electronics with lots of moving parts) are almost guaranteed to break in the first couple years. Knowing a product's reputation and reliability is vital to making your decision.
What are the terms of the extended warranty?
The terms of the extended warranty should also be considered. How long is the extension? Does it repair or replace a broken unit? Does it have a "lemon" clause where you get a brand-new replacement after a certain number of repairs? Does it cover both labor and parts? Does it cover only manufacturer's defects, or does it also include accidental damage? Does it include free cleanings/adjustments? All of these factors can increase or decrease the value of the warranty.
So...
Maybe all of this discussion seems to muddy the issue even further. However, thinking about extended warranties logically, on a case-by-case basis, is a far better strategy than blanket "rules" about whether or not to buy them. When deciding whether to buy any type of insurance, you need to take into account the chance of a repair, the cost of a repair (both the average and the maximum), your financial standing, and your level of risk aversion. For some people, extended warranties are a very bad idea. But there exists a substantial group of people for whom extended warranties are a sound and rational option.