When you buy any high-end product, from a kitchen appliance to a new car, you'll most likely be offered an extended warranty on it. Those warranties can seem like an appealing insurance policy, but they're usually a waste of money.
Think about it. Warranty companies couldn't stay in business if they paid out more in claims than they took in. Their profits come from selling coverage to people who never use it. They're betting that you won't use your warranty coverage, and they stay in business because most of the time they're right.
Still, stuff breaks down. Your car needs an unexpected and pricey repair. Your laptop blows its fan and overheats. Your fancy new washing machine turns out to have a defective motor. What should you do?
Self-insure with savings
In most cases, your best course of action is to self-insure with a savings account. Put the money you would have spent on that extended warranty into a high-interest savings account and add a little to it each month. Soon you'll have a nice little nest egg that can cover many repair issues that come up. Think of it as an emergency fund for a very specific set of emergencies.
The great thing is that your self-insurance is flexible. It can be used to pay for a car repair or a new computer or a washing machine part. If you buy a warranty, your coverage is limited to the one item you bought the warranty for. Cash is totally transferable. It can cover any repairs or accidents, provided you've saved enough of it.
Self-insurance is a great approach for handling minor problems with:
- your car (set aside enough to cover your high deductible)
- consumer electronics like computers, cameras and cell phones
By saving the money yourself, you're giving yourself the maximum flexibility in the event that something goes wrong.
Remember above, when I said that warranty companies are betting you won't use your warranty coverage, and they're usually right? If you self-insure, you're making that bet with yourself. The money is there in a savings account if you need it, but you probably won't. If you don't use it, you can roll part of it into the purchase of your next car or computer. You'll want to leave enough in the account to self-insure that item, of course.
When self-insurance is a bad idea
Self-insurance is a great alternative to extended warranties, but it's not a replacement for insurance on true big-ticket items. While you'll probably never need to use your homeowners insurance, life insurance or disability insurance, you should still have them in place. The risk of loss on these essentials is too great, and the cost of replacement is more than most of us could ever save.
How would you replace your home after a fire? What would your family do if you died suddenly? Insurance policies on your life and your home stand between your loved ones and total catastrophe should the worst happen.
You also want to maintain car insurance and health insurance. These insurance policies are different because we do use them with some frequency. You're expected to make health insurance claims at least a few times a year, when you go for your annual physical, dental visits and any other health issues that come up.
While you could pay out-of-pocket for a few doctor's visits, you probably don't have the savings to pay for a major medical situation like surgery or lengthy illness.
Real life story
Medical bills can add up fast. I was hit by a car in my early 20s, and amassed over $10,000 in medical bills just in the first few hours after the accident. The total cost was well over $30,000. That's more than my annual salary at the time.
Similarly, car insurance premiums protect you from liability in cases like this. Should you happen to hit a pedestrian (and of course you hope you don't, but accidents do happen), you'd be on the hook for those tens of thousands in medical bills. It was the driver's car insurance that paid all my medical costs after the accident I mentioned above.
When the stakes are high, and the potential costs or liabilities are more than you can reasonably save, it makes sense to pay for insurance policies that will protect you in the event of an emergency. You may never need them, but if even once in your life you need to rely on one of these policies, it will be worth more than all the premiums you've paid. For everything else, though, self-insurance could be the best bet you ever made.