PhilMur's thoughts on biz/tech/money/life

There are a variety of “warranty” products in the marketplace that masquerade as insurance, or vice-versa.

The key principle to UNDERSTAND about such plans is this: the smaller a loss you are insuring, the higher premium you will pay (as a percentage of the cost or value of the potential) to have it insured.

By contrast, collision insurance on a vehicle may cost many dollars over the course of a year, but very little as a percentage of the value of the car.  You cover more, you pay less (as a percentage of value).  A careful thinking-through of the decision, combined with such an understanding, will almost always lead you to the right decision for your circumstances.

A great example of this is the “extended warranty plan” you are often urged to consider by a Home Depot or Best Buy cashier on a moderately-sized or large purchase–although I have been offered such a plan (for $9) on small appliances costing as little as $50. Another group of products (in their case, primarily sold through car dealerships) includes items such as tire and wheel insurance and paintless dent removal.

What do all such warranty/insurance plans have in common?  They all collect a small amount of dollars from you to cover a relatively minor cost you might later incur.  The problem is this: you are paying an exhorbitant fee to maintain this type of coverage.

For example, paying $50 for 3-year extended warranty on a $250 lawn mower would be fairly typical.  And yet, that would require you to have a major repair issue within 3 years in order to “pay off”.  If you purchased such a warranty every time you bought a lawn mower, it would require you to take advantage of the insurance once for every 5 mowers you purchased in order to make sense.  Is that possible?  Maybe, but the most likely time your mower would need major repairs would be after MANY years of operation–long after the extended warranty you purchased had run out.

Another great example of this is phone equipment insurance.  Unless you are like me (I have been known to break or lose my cell phone every 9 months or so), then this type of coverage would probably not pay off.  Paying $5.99/month more on your phone bill to cover the random chance you back over it with your car, more often than not, will NOT save you money.

There are two ways to analyze such coverage to determine whether it will be financially helpful to you, or not:

1)  Calculate what percentage of the value of the item the coverage is, and think about the odds of damage occurring.  If a clothes dryer costs $400 and the 5-year extended warranty/insurance is $100,  then do you think there is a 1 in 4 chance ($400/100 = 4) of the dryer needing major repairs within 5 years?  If so, then buy the extended warranty.  If not, don’t buy it–it’s as simple as that.

2)  Determine if you could, worse scenario, fork out cash to purchase another of the same item if the one you bought was damaged or destroyed beyond repair.  If being forced to do so would devastate you financially for the week, month, or year, and keep you from paying for important things like a house payment/rent, groceries, etc., then maybe you should in fact insure that item.  This analysis is only sensible if you determine the item must be replaced in the event of loss.

The plans I have been discussing here are purchased by consumers because, quite frankly, the prospect of forking out cash for a new lawnmower, a new phone, or a new set of tires unexpectedly is often devastating to someone who may be living from paycheck to paycheck and the option of such a warranty or insurance plan seems attractive because of the low total additional cost involved.

The preferred method of dealing with unexpected losses on small items, then, is to maintain a savings account, even if just $1,000 or so, to provide a buffer for such unexpected expenses–instead of buying insurance and extended warranties on small-dollar items.  Such a strategy will save you significant dollars over the course of your lifetime.

12/21/09 Update: I recently wrote a blog posting (access by clicking here) with updated information about extended warranty products, including a source for purchasing them that offers better rates than most retailers.