Saturday, May 26, 2007

Credit Arbitrage

Put those 0%-interest credit card offers to work for you.

For the past couple of years I've been "financing" my college tuition and books with a series of 0% credit card offers. Once the 0% introductory rate runs out I transfer the balance to my next financier. All along I paid as much as I could afford each month to keep the principal low. Using this method I've gotten through a four year program without accruing much debt and without paying any interest. More importantly, since I've kept up with payments, my credit score has gotten very high (around 740) and I've built up a lot of unused credit. Now that I've graduated it's time to put some of that credit to work.

What is arbitrage?
Arbitrage is practice of taking advantage of price differences in different markets by simultaneously buying and selling commodities in the two markets. In layman's terms, arbitrage is buying low and selling high at the same time. It can be done with literally anything, but the term is typically associated with currencies, stocks, commodity goods, and interest rates.

Interest rates? How do you buy and sell interest rates?
Interest rate arbitrage is when you borrow money at one (low) interest rate and invest the same money at a higher interest rate. Sound familiar? Banks do it all the time. Think about the rates you're paying on your home loan and compare them to the interest you're earning on your savings. Even if you've done your homework and gotten really great rates on both, odds are that there are a couple of percentage points between the two.

How do I do that?
All you need is a low interest loan and a high interest investment opportunity. The key here is that the interest rate of the investment only needs to be high in relation to the interest rate of loan. If you're equipped with a mailbox, you've probably gotten at least one 0%-interest loan offer in the past week. You probably threw it in the trash. You might have even taken the extra step of shredding it first. If you can get a 0% loan, you can make a tidy profit from the interest on your savings or money market account.

What to look for.
You want the lowest rate loan over the longest period of time that you can find. Typically, credit card companies send out offers for 0% interest that are good for 6 months to a year. You don't want to pay a cash advance fee. Call your current credit card company to find out if they have balance transfer and cash advance fees.

You also need the highest rate, safest investment you can find. I recommend a savings or money market account from a local credit union. They typically offer slightly better rates than national banks, and have accounts with low or no fees. Ideally, you want an account with high interest, no fees, and free, automatic (or online) payments.

What to look out for.
You have to be careful which loan offers you choose. Some of them come with a cash advance fee, or in the case of "convenience" checks, a transfer rate of their own. Avoid these. If you have to pay a 3% transaction fee to use a convenience check from your bank or credit card company, shred the offer. The tiny profit you make on the investment won't be worth your time.

Even worse is the cash advance fee. Credit card companies often charge as much as 20% on cash advances. Needles to say, you can't use one of those cards. Find an offer with 0% balance transfer or 0% cash advance fee before you begin.

What to do.
  • Once you've been approved for the loan or line of credit, deposit the amount of the loan into your savings account.

  • If your bank has free automatic bill pay, set it up to automatically pay the minimum payment amount every month to your lender.

  • If you can't make automatic payments, make yourself a schedule to make online payments. Stick to the schedule!

  • Pay the loan back before the introductory interest rate is due to expire. If you wait until the interest rate of the loan spikes up to its normal rate, you could wipe out any profits you made on the deal.

What NOT to do.
  • Don't deposit the full amount of the loan or line of credit. Particularly if the offer is from a credit card company. The penalty for accidentally going over the credit limit will more than wipe out any profits. I recommend staying well below (10% or $500, whichever is greater) the limit.

  • Don't miss a payment. Again, the penalty will be severe. Use automatic payments if they're available.

  • Don't miss the deadline. I know it's tempting to try and squeeze every last dollar of profit from your bank, but don't do it. Pay off the loan at least two weeks before the bank's deadline. Making one month's interest payment at their regular rates will seriously impact your profits.

  • Don't spend a penny of the money you borrowed. It can be tempting to spend a little of the money sitting in your bank account. Don't. Not only will you miss out on the interest it would have earned, the funds won't be available to pay back the loan once the higher interest rates kick in.

  • Don't invest borrowed money in the stock market. It can be tempting to risk someone else's money on a higher rate of return. Don't do it. You may get a higher rate of return, but you're trading away security. You also need to keep that money liquid enough to make the monthly payments, and to pay off the loan when it comes due.

When should you not borrow?
Like any financial advice you get for free, you have to apply a little common sense. You shouldn't borrow against your credit if you already have credit card debt. You can use balance transfers to help you pay off debt you already have (like I'm doing), but pay off debt first. It doesn't make any sense to earn 5.25% interest on a money market account while paying 18.99% on a credit card. Pay it off.

I also wouldn't advise charging up a large debt if you plan to make a major purchase soon. You want to give your credit score 3-6 months to recover before buying a house or a car (or even a computer or major appliance for your home).

Finding Offers.
Check your mail. If you haven't filed for bankruptcy recently you have plenty of offers to choose from. (If you have filed for bankruptcy recently, stop reading this and pretend you never heard of it.)

CardTrak keeps an up to date listing of low-rate, no-fee credit card offers. Make sure you read the fine print. Look for offers with no balance transfer or cash advance fee.

Your own local bank or credit union is your best bet for setting up an investment account. MSN Money has an online tool for finding good rates on savings and money market accounts in your local area.

1 comment:

D. P. Roberts said...

I'd love to hear from any readers who use credit arbitrage to their advantage. If you've tried it, leave a comment. Your input could help other readers, or at least serve as a cautionary tale.