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How the Extended Warranty Rips You Off

The extended warranty was designed to turn our brains into mush because it plays on a variety of fears.


!) We're averse to risk and uncertainty, so we'll accept a worse deal for a more certain outcome;

2) We wildly over-estimate how many products fail (as an aside, if you think the product might fail, why are you buying it?); and

3) We're more likely to remember products we've broken, which only reinforces

Extended warranties, basically insurance plans for your gadgets, typically cost between 10% and 50% of an item’s price. They’re hugely profitable for retailers, but almost universally condemned by consumer advocates as a waste of money.


So why do consumers seem to find them so irresistible?


That’s the question a research team at Carnegie Mellon’s Tepper School of Business set out to answer in a new paper in the latest issue of the Journal of Consumer Research. What authors Tao Chen, Ajay Kalra, and Baohong Sun found was that people tend to overvalue products that make them happy, they tend to overestimate the likelihood that a product will need repair or replacement, and they are overly thrilled with unexpected price breaks.


Specifically, consumers are more likely to buy extended warranties for pleasurable products (such as videogame controllers) than for more utilitarian products (such as printers), they’re more likely to buy them if they’ve seen a product get lost or need repairs before, and they are more likely to buy them when they get an unexpected price break.


“For most people, they are risk averse,” says Chen of people who buy the extended warranties. What they’re really buying, she says, is “peace of mind.”


Risk aversion is just what it sounds like: Being averse to risk and being willing to accept a worse deal in return for a more certain outcome. For instance, a risk averse investor might prefer to keep his or her money in a bank, earning a low interest rate, rather than invest it in stocks, which would probably get a higher return but might also decline in value. People have different levels of risk aversion, and individuals can (and do) vary in their own risk aversion from situation to situation based on any number of factors.


One of those factors is mood. It’s been shown experimentally that people — counterintuitively — become more risk averse the better a mood they’re in. The reason appears to be that compared to a neutral mood, a good mood makes contemplating a potential loss feel worse. Basically, if you’re in a good mood, you have more to lose: Contemplating a financial loss makes you think not only of the loss itself, but also of the loss of the good mood.


Thus, when people think about their new iPod falling into the tub or their new digital camera getting smashed on the ground, it causes them more mental anguish than the prospect of their toaster breaking (unless they absolutely love making toast).


But risk aversion isn’t the whole story. It also seems clear that people are wildly overestimating the chances of products failing to begin with. Consumer Reports data show that most categories of electronics are far less likely to break down than one might think. For instance, across 10 brands of televisions, the overall failure rate after four years is 3%. For digital cameras, the rate is 10%. The highest rate was for laptops computers, at 43% — but that includes spills and other accidents not typically covered by warranties.


But, according to the paper, people’s purchasing behavior seems to indicate that they think products are about twice as likely to break down as they actually are. This certainly jibes with what we know about the availability bias — a cognitive bias where the things we’re most easily able to conjure to mind shape our understand of what’s likely to happen in the future. We remember the products we’ve broken, especially if they cost us money to repair or replace; we don’t remember the ones that worked perfectly.


So, as all these biases tug on your brain this holiday season, here are a few things to keep in mind that might save you from wasting your money. First, extended warranties are huge profit centers for retailers — because they’re getting you to pay a lot for something that costs them little to nothing. Second, even if you do end up needing to repair a product, that repair, according to Consumer Reports, will cost on average the same as the warranty; you might as well only fork over that cash when the item has actually broken.

Smart Money