The idea of an extended warranty is simple: for a small fee, all repairs for a period are covered by the store providing the service. These may seem like an attractive option; for only a few dollars a month, the store will pay hundreds for a potential repair. Many stores offer warranties on expensive purchases, especially on big-ticket consumer electronics. However, there is a profit motive behind offering these warranties, and this motive accounts for the reason extended warranties make no sense for the consumer.
In an extended warranty plan, for a one-time fee, or a couple of dollars a month, the service provider will pay for repairs to the covered item. Obviously the per month cost of the plan, or the plan in total is less than an expected repair bill. This is an attractive option, as repair bills for appliances can be hundreds of dollars, or even require the complete replacement of the product. However the provider would not offer these warranty plans at a loss to themselves. On the contrary, they build the cost of the potential repairs right into the cost of the plan sold to the consumer.
An example might be the extended warranty on a new television. For a few dollars a month, the store will cover any repairs required by the new television. But how much should the store charge for this? To set their price for the extended warranty, the store calculates the average repair bill for the television, adjusted by the likelihood the television will need repairs. The resulting price would be the cost to the store to repair the average number of problematic televisions.
For a simplified example: suppose this television would cost on average $500 total to repair. Approximately 2% of the covered televisions have a problem per month. To repair all covered televisions would cost $10 per month. Hence the store would have to pay $10 per month to cover all repairs. All things equal, this would also be the average cost to the consumer: the price of a repair, weighted against the likelihood of a problem occurring.
However, the store also has a motive to make money in the process, and they will almost always build a profit figure into their price. If the average cost of repairs comes to $10 per month, the store would charge a premium for their own gain. This is not accounted for in the statistical derivation of the extended warranty's per month cost. This usually results in the store charging more than what it would statistically cost to repair the television. By charging for example $12 per month for the extended warranty, the store makes $2 per month per plan (if the statistics are accurate). Ignoring overhead, this is 20% profit. Some stores charge as much as 50% or more on extended warranties, all at the customer's expense.
While most extended warranty plans are designed to cost the consumer more in the long-term than they statistically save, some extended warranty plans have other benefits. Repairs for essential items such as automobiles or homes may be too expensive at one time, but the consumer has no option but to pay for repairs immediately. If the cost of a repair is more than the consumer could afford at once, warranty programs can help spread the cost over several months or years.
Most consumer warranty programs are not worth the price. If the statistics are accurate, and the store is interested in making a profit (they all are), most consumer warranty programs are priced significantly higher than their cost. This is inherent to their design, so they are almost never worth it.
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