What are the Risks of Credit Card Arbitrage?
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| What are the Risks of Credit Card Arbitrage? |
Is it really feasible to earn "money for nothing" as Dire Straits claimed in their 1985 hit song? People who earn from credit card arbitrage answer yes. But is it a clever strategy to fight the credit card issuers at their own game, or just a reckless method to rack up high-interest debt and ruin your credit score?
What is Credit Card Arbitrage?
Arbitrage is the practice of purchasing an investment vehicle at a cheaper price and then selling it at a higher price, benefitting from the price difference. Credit card arbitrage is the practice of borrowing money from credit card issuers and investing it in an asset with a higher interest rate than the one you're currently paying.
Here's how it works: you get an offer in the mail from a credit card business guaranteeing a zero percent or low-interest rate on transferring your balance from an existing card. You complete the papers and write out one of the pre-printed checks the corporation delivers with the offer payable to you. Alternatively, you may fill out the application online and specify where the money will go.
Next, conduct some research to discover a high-yield savings account, CD, or other vehicle with a higher interest rate. From there, you invest the money, paying at least the minimum monthly payments on schedule, and after the first lower "teaser" rate ends, take the money, pay the card's balance, and pocket the difference as profit.
Here's how it works: you get an offer in the mail from a credit card business guaranteeing a zero percent or low-interest rate on transferring your balance from an existing card. You complete the papers and write out one of the pre-printed checks the corporation delivers with the offer payable to you. Alternatively, you may fill out the application online and specify where the money will go.
Next, conduct some research to discover a high-yield savings account, CD, or other vehicle with a higher interest rate. From there, you invest the money, paying at least the minimum monthly payments on schedule, and after the first lower "teaser" rate ends, take the money, pay the card's balance, and pocket the difference as profit.
Risks of Credit Card Arbitrage
It's a simple method to earn money for free, right? In fact, it's not that straightforward, and it may cost you more than you can afford.
Proponents of credit card arbitrage argue that the zero percent, or low-interest rate, allows users to get cash at a free or cheap cost. And if the borrower repays the whole amount on time, it demonstrates that they can manage and repay the loan, which may improve their credit score. However, Avi Karnani, co-founder of the financial planning website Thrive, said in a phone interview, "It's a gamble like no other."
The following are some of the major hazards of utilizing a credit card to finance your investments.
Proponents of credit card arbitrage argue that the zero percent, or low-interest rate, allows users to get cash at a free or cheap cost. And if the borrower repays the whole amount on time, it demonstrates that they can manage and repay the loan, which may improve their credit score. However, Avi Karnani, co-founder of the financial planning website Thrive, said in a phone interview, "It's a gamble like no other."
The following are some of the major hazards of utilizing a credit card to finance your investments.
1. Poor investments
One of the fundamental assumptions of credit card arbitrage is that you can discover a "safe" investment that will provide a much better rate of return on the money you borrowed to invest. However, in today's challenging economic climate, such automobiles are more difficult to come by.
"People who traditionally do arbitrage well are investment professionals," according to Karnani. "Why should anyone recommend it for the average individual as a way to make a relatively small amount of savings?"
When credit card issuers start withdrawing 0 percent offers or abruptly changing the rules to charge you extra for your borrowing, the 3% interest rate from a high-yield savings account won't make you any money. And don't simply consider the interest you might earn. You need to understand the terms of the investment you are making. If you needed to withdraw your money early, would you be penalized? How much?
"People who traditionally do arbitrage well are investment professionals," according to Karnani. "Why should anyone recommend it for the average individual as a way to make a relatively small amount of savings?"
When credit card issuers start withdrawing 0 percent offers or abruptly changing the rules to charge you extra for your borrowing, the 3% interest rate from a high-yield savings account won't make you any money. And don't simply consider the interest you might earn. You need to understand the terms of the investment you are making. If you needed to withdraw your money early, would you be penalized? How much?
2. Develop a debt habit
Engaging in practices such as credit card arbitrage often has unintended psychological consequences. "It encourages terrible financial behavior," explains 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."
3. Default on the loan
The money you get from the credit card company is a loan. If you fail to repay the firm in accordance with the conditions of the loan, you are in default. When this occurs, you will be charged a late fee, but more crucially, the credit card company may quickly modify the conditions of your loan and levy a substantially higher interest rate, often 19% to 29%. Costs may soon build up, wiping out any financial advantage and leaving you with debt that might take months or years to pay off.
Unexpected life circumstances might rapidly drain the liquidity you planned to utilize to make monthly payments. "Credit card arbitrage works great on paper, but the problem arises when someone loses their job, becomes extremely ill, or has a major accident," explains Kendall Peterson of CreditWhisperer.com. "It puts you in a position where you suddenly owe more money than you can pay off. Nobody intends for such things to happen to them."
Unexpected life circumstances might rapidly drain the liquidity you planned to utilize to make monthly payments. "Credit card arbitrage works great on paper, but the problem arises when someone loses their job, becomes extremely ill, or has a major accident," explains Kendall Peterson of CreditWhisperer.com. "It puts you in a position where you suddenly owe more money than you can pay off. Nobody intends for such things to happen to them."
4. Setbacks in credit scores
Credit card arbitrage may harm your credit score in various ways:
Opening a new line of credit often lowers your credit score.
Borrowing money with the new card raises your usage ratio (the amount of credit you have available vs. how much you're presently using). A greater usage ratio leads to a worse credit score.
Though the debt-to-income ratio (DTI) is not on your credit record, a high DTI might affect your ability to get loans such as a mortgage.
Making even one late payment may be disastrous, since timely payments contribute around 35% of your entire credit score.
Opening a new line of credit often lowers your credit score.
Borrowing money with the new card raises your usage ratio (the amount of credit you have available vs. how much you're presently using). A greater usage ratio leads to a worse credit score.
Though the debt-to-income ratio (DTI) is not on your credit record, a high DTI might affect your ability to get loans such as a mortgage.
Making even one late payment may be disastrous, since timely payments contribute around 35% of your entire credit score.
5. Rule changes
According to Curtis Arnold, proprietor of Cardratings.com, "The rules of the game have changed." It's a challenging atmosphere." What was once considered hard and fast in the credit world is changing overnight." Credit card firms are not obligated to provide early notification, so you may not even notice the conditions have changed. "You toss out a letter that looks like junk mail, but it's actually notifying you of important changes on your account," Arnold reveals.
Companies might modify your payment due date, billing cycle, interest rate, and surcharges without your knowledge. The consequences may be severe. "Say you borrow $10,000, and overnight the company eliminates the cap on the offer," Arnold proposes. "Suddenly you're charged three percent interest on your loan balance, which means you now have to pay at least $300 for the loan; the rate of return on your investment must match up for you to net a profit."The Bottom Line
While some individuals may have the financial discipline and ability to participate in credit card arbitrage, there are substantial hazards that must be considered. "Gone are the days of generating a lot of money this way; it's a dangerous enterprise. However, there are still certain offerings available that may make sense for persons with the correct attitude and discipline," adds Arnold.
Arnold recommended the following strategies for increasing your chances of success.
Examine the conditions of the credit card company's offer.
Do the arithmetic to ensure that once expenditures are deducted, it will provide a respectable rate of return.
Create an auto-pay mechanism for the monthly payment.
Join an online social media community to stay up to date on the newest industry trends, traps, and recommendations.
Look for balance transfer deals that have no expiry date. These deals may have a higher interest rate, but you may lock in that rate until you pay off the bill in full, allowing you to dramatically prolong your investment timeline.
Prepare a backup plan for swiftly accessing liquid funds and repaying the loan in full, if required.
If you follow all of these procedures, you have a greater chance of making credit card arbitrage work, but it is still a hazardous strategy.
Companies might modify your payment due date, billing cycle, interest rate, and surcharges without your knowledge. The consequences may be severe. "Say you borrow $10,000, and overnight the company eliminates the cap on the offer," Arnold proposes. "Suddenly you're charged three percent interest on your loan balance, which means you now have to pay at least $300 for the loan; the rate of return on your investment must match up for you to net a profit."The Bottom Line
While some individuals may have the financial discipline and ability to participate in credit card arbitrage, there are substantial hazards that must be considered. "Gone are the days of generating a lot of money this way; it's a dangerous enterprise. However, there are still certain offerings available that may make sense for persons with the correct attitude and discipline," adds Arnold.
Arnold recommended the following strategies for increasing your chances of success.
Examine the conditions of the credit card company's offer.
Do the arithmetic to ensure that once expenditures are deducted, it will provide a respectable rate of return.
Create an auto-pay mechanism for the monthly payment.
Join an online social media community to stay up to date on the newest industry trends, traps, and recommendations.
Look for balance transfer deals that have no expiry date. These deals may have a higher interest rate, but you may lock in that rate until you pay off the bill in full, allowing you to dramatically prolong your investment timeline.
Prepare a backup plan for swiftly accessing liquid funds and repaying the loan in full, if required.
If you follow all of these procedures, you have a greater chance of making credit card arbitrage work, but it is still a hazardous strategy.