In the summer of 2011 when I bought my first car from the Toyota dealership, the dealer pressured me to buy an extended warranty on my 2011 Corolla S. It would cover my car for four years and some number of miles (forgot the details) after the manufacturer warranty expired.

My immediate reaction was an emphatic “Hell No.” I wasn’t planning to drive very much–not close to their mileage limit, so would not be benefiting much from the warranty.

But he said, “If you don’t use the warranty, you’ll get your money back at the end.” I raised my eyebrow to that, because at that point it seemed nearly “free” (in a world where real interest was basically zero). Without fully inspecting the conditions under which I will get my money back, I agreed to the deal. I paid $3000 now to cover unknown risks 3-7 years from now, convinced that I paid a small cost for the insurance.

Weeks later when I reflected upon that decision, I realized I made a few mistakes:

  • I was using the wrong discount rate. I was entrusting the dealer (not the manufacturer) with providing a service or returning my money. The “option” cost was therefore $3000 minus the present value of $3000 in 7 years, discounted by the 7-year bond rate for the dealership. For example, if the dealership raised debt at 5% real yield, I would be getting back a present value of $2132, for an option cost of $868. And that’s if I was willing to buy their debt (undiversified), which I was not.
  • I didn’t inspect the details of what the extended warranty covered–Was it only manufacturing defects? Who’s to say whether some defect is a manufacturing defect? All of these things are important, and I glossed over them because I thought the option cost was negligible.
  • I didn’t inspect the details of how I can get my money back. What if they had a provision that failing to maintain my vehicle as scheduled once in the 7 year period will disqualify me? What if they included using the manufacturer warranty under that condition? What if it required the vehicle to remain with the same owner the whole time?
  • Seven years after purchase, the car will be worth less than $10,000 (present dollars). Does it make sense to pay $3000 in present dollars to insure against defects against a $10,000 car?
  • If I decide to part with my car, the buyers may not appreciate the value of the extended warranty as much, perhaps for the reason above.

When I purchase my next car, I will probably not buy an extended warranty from the dealer unless I (1) plan to drive a lot, but still under their limits, (2) have the opportunity to understand and evaluate the offer, and (3) expect to keep the car for a long time.

For a perspective from early 2009, see Extended Warranties.