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Extended warranties: A high-priced gamble

Survey of 8,000 new-car buyers shows they are usually a poor deal



Most people don't buy a new car without hearing the dealership finance manager warn about "how foolish it would be" not to protect your investment from unexpected repairs as you put on the miles. What comes next is a persistent sales pitch for a solution to your new fears: an extended warranty. "You could save the amount of the plan cost with just one covered repair!" says a brochure for Ford's Extended Service Plan.

But extended warranties sell costly "peace of mind" for repair nightmares that probably won't occur, according to a survey of more than 8,000 readers in December 2007 by the Consumer Reports National Research Center. We have long advised that extended warranties are a poor deal for almost every product. Now we have the first data showing that this advice applies to most new cars as well.

The survey included buyers of extended warranties for cars in the 2001 and 2002 model years. That allowed sufficient time for the factory warranties to expire, as well as several years of extended coverage. The chart on Costly contracts lists results for makes for which we have sufficient data; note that models within a make may vary. Some owners in the survey might have had coverage remaining, but our analysis shows that the need for serious repairs is uncommon.

The main reason is that automobiles today are more reliable than ever. "The odds are that what's covered won't fail," says Terry Wynter, who owns Terry Wynter Auto Service Center in Fort Myers, Fla., and is helping to write an extended-warranty guide for the Automotive Service Association (ASA). The sellers of extended warranties know what parts tend to break within the coverage time and mileage, so buyers are betting against the house.

In fact, that's a lesson many people already know. About 75 percent of all respondents in our initial screening did not buy extended warranties, with more than two-thirds saying they didn't think it was a good value for their money.

The best course of action for most consumers is to buy a car that gets top reliability scores in our Vehicle Ratings , and you probably won't need an extended warranty. But if your heart is set on a car with a below-average reliability record, it's more of a toss-up. You can decide for yourself how much "peace of mind" is worth. For example, the highest usage claims were for Mercedes-Benz, for which we have no recommended models due to below-average reliability. But only 38 percent of those owners said they saved money with the extended warranty; the average loss was $100.

The experience of our readers who bought extended warranties and a closer examination of how they work show why the odds are stacked against you.
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How they work




1. NOT INSURANCE, NOT A WARRANTY

Many consumers think of extended warranties as insurance. That's not by accident. Marketing materials promise "peace of mind," or "fully insured," describe their business as "insurance-related," and point to their financial "strength and stability."

But extended warranties are not insurance in most states. They're not even warranties as defined by federal law. These arrangements are most accurately described as prepaid repair contracts, also known as extended service contracts. Here's how they work:

A car dealer usually sells a contract that is handled by independent auto warranty companies called administrators. The dealer just makes the sale, so the contract is between you and the administrator, which might be a carmaker's subsidiary or a separate company. The administrator pays the repair shop or reimburses you only for covered problems. Another company might insure your contract against default.

"Auto extended warranty companies are not subject to the same close regulation and oversight as insurers," says Jane Cline, the insurance commissioner of West Virginia, who spoke with us on behalf of the National Association of Insurance Commissioners. That means that buyers of extended service contracts in states that don't consider them to be insurance don't enjoy the same regulatory safeguards that they get from, say, auto insurance, whose price must bear a reasonable relationship to cost.


2. HIGH SALES COMMISSIONS

Since extended service contract pricing is not regulated, dealers charge whatever the market will bear, and a 50 percent cut for sales commissions is not unusual. That means on a $1,500 to $2,300 contract, $750 to $1,150 can go to the administrator, minus that company's own costs and profits.

By contrast, only 17 percent of your annual premium for auto insurance goes to commissions and other selling expenses. On average, dealers collected $795 per new-car extended service contract last year, according to Superior Integrated Solutions, a dealer management consulting firm. Such sales contributed 14 percent to dealerships' bottom line, according to CNW Marketing Research, which covers the automobile industry.

Stephanie Marquis, a spokeswoman for the Washington State Insurance Commissioner's Office, says if there's a state-licensed insurance company or lesser-regulated risk-retention group behind the plan, "only $300 actually goes to the insurance company" in her state.

In other words, a very small portion of the price you pay for an extended service contract actually goes to repairs after intermediaries get their cut.


3. UNLIKELY CATASTROPHE

The standard sales pitch for extended service contracts includes invoking fears about the breakdown of big-ticket items. Promotional materials for the GM Protection Plan, for example, show an array of pricey internal parts under the skin of an SUV—$1,200 for an air-conditioning compressor, $2,600 to replace the transmission, $7,300 to switch out an engine.

Concern about future repairs is what mainly drove people to sign up for an extended service plan, but for the most part, their worst fears did not materialize. Plans were used by 58 percent of buyers, and the average repair savings were less than what they paid for the contract. Only about a third of all respondents who bought an extended warranty actually used their plan to cover a serious problem.

Another way to look at this is through the experiences of people who had vehicles four to six years old and who did not have extended warranty coverage.Analysis from our extensive reliability database showed that only about 4 percent of those cars had repair costs of more than $1,700 in a one-year period, and fewer than 1 percent had $3,700 in such costs.

A Ford official acknowledges that big-ticket repairs are rare during the life of its biggest-selling five-to-six-year Premium Care Extended Service Plan. "What you tend to see is a few small repairs as the vehicle gets older," says Mark Bardusch, Ford's ESP sales manager. "Major repairs are decreasing." But Bardusch says Ford's plans, for which consumers pay about 2 percent of the vehicle price per year of extended service, are a much better deal than those offered by the home-appliance industry, which usually charges a higher percentage of the product's price.


4. TRICKY COVERAGE TERMS

The contracts offer seemingly generous periods of coverage, up to eight years/120,000 miles. But you get less than meets the eye. If you buy a plan when you purchase your vehicle, as 82 percent of our respondents did, you pay to finance the deal up front, and the meter on the plan typically starts running that day.

But the core coverage doesn't kick in until after the original factory warranty is up. About 37 percent of respondents who didn't use their extended service contract to cover repair costs said they didn't collect because the problem was covered by the factory warranty.

For example, if your Honda comes with a common three-year/36,000-mile factory warranty, the Honda Care eight-year/120,000-mile extended service really only covers repairs for the last five years or 84,000 miles, whichever comes first. Factory warranties on some cars are getting better. General Motors and Chrysler recently increased their powertrain warranty. Hyundai for several years has had a long powertrain warranty.




5. LOTS OF FINE PRINT

Many brochures we reviewed tend to wax eloquently about "comprehensive" coverage for hundreds of parts and other benefits. Those sales tools usually don't say much about numerous exclusions and limitations. To learn that, you need to delve into the contract:

Wear and tear. More than 57 percent of survey respondents who bought a contract when they purchased their car did so to guard against problems that develop as cars get older. A number of extended service contract brochures we examined said or suggested that the plans cover "wear and tear," which can be a confusing term.

In general, it means a covered part will be replaced if it dies prematurely during its expected lifetime, suggesting that it is associated with some hidden defect or is simply the bad egg of its production lot. Extended warranties, however, typically don't cover parts and labor related to normal wear items, such as brake pads, rotors, shock absorbers, belts, hoses, etc. A potential sticking point is how "normal" and "premature" are interpreted.

Covered part not covered. Ford's ESP contract, like some other agreements, does not cover "repairs needed to a covered part caused by the failure of a non-covered part."

Remember that worst-case worry about replacing the engine? If your fan belt, a part not covered, broke and caused the engine to overheat, the engine repair might not be covered. "We would have to see why the fan belt failed," Bardusch says.

Reasonable cost. Contracts can be imprecise in their promise to pay "reasonable" labor rates and parts costs. After Robert Cleaves, 77, spent $4,000 for an extended service contract, Warrantech, of Bedford, Tex., wouldn't pay more than $1,435 of an $1,825 claim on his 2002 Mercedes-Benz, based on its definition of "reasonable" labor and parts rates. So Cleaves, a retired Los Angeles attorney, sued, prompting full payment. "If I had that $4,000 now, I'd be money ahead," says Cleaves, who now counsels against buying such contracts.

Sometimes "you're dealing with a claims adjuster whose function is to pay as little as possible," says Bill Moss, co-owner of Advantage Certified Auto Group in Manassas, Va., and another author of the ASA's extended-warranty guide.

Tear-down diagnosis. A repair shop may take apart an engine to determine the cause and cost of repair. "You will be responsible for these charges if the failure is not covered," says Warranty Direct's MajorCare contract.

No maintenance records. All extended plans require that you perform and pay for regular maintenance according to the owner's manual. But they can deny claims if you can't produce records of that maintenance.


6. BANKRUPTCY RISK

Even if you follow all the rules, you still might not be able to collect on your plan because the administrator went bust. Last year Ohio-based Ultimate Warranty left more than 137,000 customers holding the bag on an estimated $45 million in expected claims. Tim Meenan is executive director of the Service Contract Industry Council, a trade group that has been effective in pushing industry-standard regulations for service contracts in more than 25 states. He says: "There used to be a tremendous amount of insolvencies in this business. There still are, though we've reduced that number."

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We can do without any article of luxury we have never had; but once obtained, it is not in human nature to surrender it voluntary.