Credit Card Warranty Asset Pricing

As I mentioned at TravelCon I recently renovated my home and bought an array of appliances for the kitchen.  I calculated that the biggest discount would be to buy Giftcards with double stacked rebate: 5% from the Old Blue Cash Amex and another 17% or so from Gas rewards.  This path did create a future interest risk (the Gas rewards are not cash until redeemed and can be forgotten about). Another path would be to buy discounted giftcards from raise.com or other sites and pocket the coin today.

A reader mentioned that buying with Gift Cards removes the extended warranty that comes with a credit card.  Let’s examine this factor today, and see how it should be correctly priced as an asset.

American Express Extended Warranty

Amex has a great extended warranty. It will add a year on to warranties of 1-5 years duration, and match warranties of less than one year (doubling them). But what’s that worth?  There are many things to consider, probably the most important is the correlation between the length of the warranty and the product purchased.  There aren’t many items in the home that will be more expensive in 5 years time.  So with that in mind we need to keep an eye on some key concepts:

• Depreciation – the value of your product tends to depreciate with time, this ties in with concepts like Moore’s Law.
• Moore’s Law this applies to computers, stating that they seem to double in performance (transistors) every two years. This means that in 5 years time the actual like for like replacement cost of certain products will be vastly different from today.  While Moore’s law applies to computers, its concepts are more broadly reaching in the home, and most of the stuff you have today that is considered high end will be mediocre in 5 years.
•  You are NOT leasing – some people think it is worth a premium to be insured with a ‘like new’ replacement value. We see this trend in auto insurance.  However, you aren’t leasing a product in the hope it will fail on year 6 to be replaced via credit card insurance. Keep that in mind.

Remember, warranties are simply a form of insurance.  Not everything need be insured.  In fact, unless it has a high impact and a low chance of happening I would rather self insure whenever possible. Don’t forget secret fees.  Just like in financial advice, people gravitate to products sold by advisors who charge no fee. But the reality is that the fees are baked into the product.  When it comes to Credit Card insurance it is the same thing, the fee is baked into it.  The fee can be seen via the opportunity cost.

The Math

It is important to start out with the concepts because then we know what we are looking for in the math. This reduces the Garbage In/Garbage Out threat that happens when we explore value.  There’s actually a lot of math going on here.  For one we could look at the actual value of the insurance, we could look at a time value of money equation.  In the time value of money we are looking to solve at least 1 variable that is unknown:

1. Present Value
2. Future Value
3. Time
4. Payment
5. Interest Rate

The trick is transposing the Credit Card warranty cost into this equation.  We start with determining the variables we know as certain.

Time is fixed. Although it must be adjusted for each iteration we know it will be something between (1-5 years +1) or (0-1 year x 2).

Present Value can be determined by the acquisition cost spread.  That means if you select your Amex SPG card for the warranty you would earn 1 SPG per dollar. If we transliterate that to a dollar value (insert yours) then we compare that with the GC route we create a Present Value spread.

EG: Lowes Gift Card with an 8.1% discount VS SPG for a $1000 refrigerator:

• GC Cost = $919 (rebate of $81+SPG)
• SPG Cost = $1000 (rebate of 1000 SPG at say 1.5 cents = $15)

GC Cost-SPG Cost = Spread = $81 = Insurance Premium.

Interest Rate = Subjective to your highest opportunity.  This means if you have no investments, but have a debt of 7% APR you would be able to gain a 7% return by applying the money saved in Insurance Premium to your debt. If you are in the market then you could use a number that reflects your asset allocation, likely between 4-8%.

We know Payment to be zero, so we can now solve for Future Value. In other words, we can determine how much money this would be worth in years to come:

The million dollar question

What does that chart mean?  It shows the future value of your savings if you elect to NOT insure.  For example, should your opportunity interest rate be 7% and your Warranty be 3 years then you are deciding whether you want to buy a 1 year warranty 3 years from now for $99.23

Since the premium is now $99.23 and the initial purchase price was $1000. For simplicity, lets consider that an 100/1000 fraction, which is 1/10.  The question here might appear to be, do you think that in 3 years from now you have a 1 in 10 chance that the product will breakdown? But don’t forget depreciation and Moore’s Law either:  that $1000 refridgerator might only cost $800 in 3 years time.. so that changes it to a 1/8.

The spread between 1/8 and the actual chance of it breaking down is the money you are leaving on the table when using insurance.

Note..  this fails to address is the probability of claim.  While some might argue that due to decay, products are more likely to fail later rather than sooner, that does not factor in the time to failure from a faulty product.  In other words if you bought a lemon, it may well reveal itself as one within the first year.  This is something that you can notice in actuarial tables -while all people will eventually die, average life expectancy from birth is different from when you start at age 21.

It’s only $100!

I think this is the common approach.  But let me bring in another concept.. diversification.  The notion of diversification is that in a broad mix you can afford a lemon. You buy the farm, so if one thing goes wrong the good things can cover it.  In the present context lets consider that the kitchen has many appliances, such as: Range, Dishwasher, Microwave etc.  Each one has an 8.1% rebate opportunity here, collectively this could create a self insurance ‘pool’ where the money that you save by not insuring the Refrigerator, can pay to replace the Microwave.

Understanding Future Interest Risk

This concept of insurance ties into the notion of ‘buying risk’ part of what you are saving when electing to use a gift card vs a credit card is the risk premium for warranties.  However, we must remember that a combination of manufacturers warranty and overall homeowners insurance (catastrophic loss) cover certain ranges within the risk spectrum. As such, credit card insurance is a ‘filler’ insurance and for me, the value it offers is not worth the premium it demands.  These little 8% decisions make a massive impact to your overall finances, especially when spending large sums of money on renovations.

A trickle down effect of me refusing to pay for credit card warranties and electing to self insure is that I have also adjusted my home owners deductible up to $2500 which reduces annual premiums.  In other words, I am covered by the insurance for catastrophic losses, but I’ll take the heat if something minor breaks down.