Is it really possible to make "money for nothing" like Dire Straits sang in their hit single from 1985? People who profit from credit card arbitrage say yes. But is it a smart way to beat the credit card companies at their own game, or a risky way to accumulate high interest debt and pummel your credit score in the process?
What Is It?
Arbitrage is the process of simultaneously buying an investment vehicle at a lower cost and selling it at a higher price and profiting from the difference in prices. Credit card arbitrage involves borrowing money from credit card companies, then investing that money in an instrument offering a higher interest rate than what you're paying.
Here's how it works: you get an offer from a credit card company through the mail promising a 0% or low interest rate to transfer your balance from an existing card. You fill out the paperwork and make out one of the pre-printed checks the company sends with the offer payable to you. You do a little homework to find a high-yield savings account, CD or another instrument offering a higher interest rate. Invest the money, make at least the minimum payments each month on time and, when the initial lower "teaser" rate expires, withdraw the money, pay the balance owed on the card, and keep the difference as profit. (See our article Are You Living Too Close To The Edge? for more.)
It's an easy way to make money for free, right? In reality, it's not that simple, and it can actually cost you more than you can afford.
Proponents of credit card arbitrage point to the fact that the 0%, or low interest rate, enables consumers to obtain capital at no or low cost. And if the borrower repays the entire amount on time, it can demonstrate that they're able to manage and repay debt which can, in turn, potentially boost their credit score. But as Avi Karnani, co-founder of the financial planning website Thrive said in a phone interview, "it's a gamble like no other."
Risk No.1: Making a Poor Investment Choice
One of the underlying assumptions about credit card arbitrage is that it's possible to find a "safe" investment that will earn you a significantly higher rate of return on the money you borrowed to invest. But in a difficult financial environment, those vehicles are harder to find. "People who traditionally do arbitrage well are investment professionals," notes Karnani. "But if they're clearly having a tough time doing it in today's distressed financial environment, why should anyone recommend it for the average individual as a way to make a relatively small amount of savings?"
When credit card companies begin pulling back from 0% offers, or suddenly change the terms to charge you more on your loan, the 3% interest rate from a high-yield savings account isn't going to net you any profit. And don't just look at the interest you could earn – you've got to know the terms of the investment you're making. If you needed to withdraw your money early, would you be charged a penalty? How much?
Risk No.2: Creating a Debt Habit
An often unforeseen consequence of engaging in behaviors like credit card arbitrage is actually psychological. "It encourages terrible financial behavior," says Karnani. "It's not financially healthy for people to get used to seeing large numbers on their credit card statements and carrying high levels of debt."
Risk No.3: Defaulting on the Loan
The money that you get from the credit card company is a loan. If you fail to repay the company according to the terms of the loan, you're in default. When that happens you'll be charged a late fee but, more importantly, the credit card company can immediately change the terms of your loan and charge a much higher interest rate - think 19%, 29% or higher. Costs can mount quickly, and not only nullify any financial gain, but actually saddle you with debt that could take months or years to repay.
Unexpected life changes can quickly deplete liquidity you may have been planning to use to make the monthly payments. "Credit card arbitrage works great on paper but the trouble comes when someone abruptly loses a job, gets extremely ill or has a major accident," says Kendall Peterson of CreditWhisperer.com. "It puts you in a situation where, overnight, you owe more money than you can pay off. No one plans for those types of things to happen to them." (For more, read The Importance Of Your Credit Rating.)
Risk No.4: Hurting Your Credit Score
Engaging in credit card arbitrage could hurt your credit score in several ways:
- Opening a new line of credit typically hurts your score
- Borrowing money on the new card increases your utilization ratio (how much credit you have available : how much you're currently using). Higher utilization ratio = lower credit score.
- Increasing your overall debt to income ratio is a negative.
- Making just one late payment can spell disaster, as timely payments account for 30% of your overall credit score. (For more, see Consumer Credit Report: What's On It.)
Risk No.5: Finding Out the Rules Have Been Changed
According to Curtis Arnold, CEO of Cardratings.com: "The rules of the game have changed. It's a tough environment. What was considered hard and fast in the credit world is being changed overnight." Credit card companies aren't required to give advance notice, and you may not even realize the terms have changed. "You toss out a letter that looks like junk mail, but it's actually notifying you of important changes on your account," says Arnold.
Companies can change your payment due date, shorten your billing cycle, raise your interest rate and add fees all without you being aware of the change. The implications can be serious. "Say you borrow $10,000, and overnight the company eliminates the cap on the offer," says Arnold. "Suddenly you're charged 3% interest on your loan balance which means you now have to pay least $300 for the loan; the rate of return on your investment must match up for you to net a profit." (For more, see How To Read Loan And Credit Card Agreements.)
While some people may have the financial discipline and capacity to engage in credit card arbitrage, there are significant risks that should not be overlooked. "The days of making a lot of money this way - it's a risky venture. However, there are still some offers out there that might make sense for people with the right approach and discipline," says Arnold. To have the highest probability of success, Arnold gave the following tips.
- Carefully read the terms of the credit card company's offer.
- Do the math to make sure that after expenses are paid, it's going to pay a reasonable rate of return.
- Set up an autopay system for the monthly payment.
- Join an online forum to learn the latest industry trends, traps and tips.
- Look for balance transfer offers with no expiration dates. These offers may have a higher interest rate but you can lock in that rate until you pay the balance off in full, which significantly extends your investing time horizon.
- Have a "plan b" – a way to quickly access liquid savings and repay the loan in full if necessary.
If all of these steps are followed, you have a better chance at making credit card arbitrage work, but it's still a risky maneuver. (To read more about credit cards, see our related articles Six Major Credit Card Mistakes, Understanding Credit Card Interest and Cut Credit Card Bills By Negotiating A Lower APR.)
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