Several years ago, credit card arbitrage was all the rage. It’s hardly original – traders have been seeking arbitrage opportunities for many more years than that, and today the big investment banks essentially run on arbitrage and similar schemes. However, is credit card arbitrage really all that it was stacked up to be? Before you race to fill out that stack of shiny credit card applications, here are three important reasons to reconsider.
– About Credit Card Arbitrage –
It’s a deceptively simple scheme. Instead of reflexively tossing into the trash the scores of “pay no interest for six months!” credit card offers which regularly land in your mailbox, you actually fill them all out. The banks reward you with large amounts of cheap credit, which you then withdraw as cash advances, and deposit in a high-interest savings account (or a term deposit, if the bonus no-interest period lasts for a year or more). At the end of the no-interest period, you pay back the balance in full, and pocket the interest you earned along the way. Rinse and repeat – with as many credit cards as possible.
Essentially, this is no different than any other type of arbitrage trading – which means taking advantage of an imbalance between the price of a given asset in two different markets. In this case, the “asset” in this question is simply cash: credit card companies are willing to charge you less to give you the money than some banks with high-interest accounts and term deposits are willing to pay you in interest for the very same money.
At the same time, there are some some major risks involved. It would be overly simplistic to say that credit card arbitrage doesn’t work. However, it’s certainly difficult to run successfully for very long, and the time and money invested in this scheme could be just as profitably put to other uses. Essentially, credit card arbitrage might work, but it doesn’t work very well.
– Recession Economics –
The first reason that credit card arbitrage doesn’t work very well is essentially a temporary problem related to the recession. Several years ago, when both credit card arbitrage and the economy in general were peaking, high interest savings accounts were so lucrative that they essentially qualified as low-risk investment strategies. Plus, the banks were giving out credit like candy, making it very easy to acquire several new credit cards at minimal cost.
Times have changed, however. It is still not too difficult to get a new credit card, but the bonus periods are getting shorter and scarcer. More importantly, the high interest savings market is drying up because of the extremely low interest rates maintained by the Federal Reserve. The result is that it is harder to get cheap credit, and it is harder still to make any money with it. As a result, even run perfectly, a credit card arbitrage scheme today simply can’t make more than a fraction of what the same scheme would net in, say, 2006. At that time, you could easily find a savings account paying well over 3%; now, you’ll be looking at half the returns. Taking on $100,000 in new credit card debt could still net you potentially a couple of thousand dollars per year, however.
– Red Tape and Due Dates –
The second reason that credit card arbitrage doesn’t work very well is, unfortunately, a more permanent reason. Credit card signup bonuses relieve you of having to pay interest for a fixed period – which is precisely the opportunity that credit card arbitrageurs are exploiting. However, they do not relieve you of the other obligations for the card. In particular, you still have to make the minimum monthly payments on schedule.
It gets worse. In general, the signup agreements specify that if you miss any of these payments, they will immediately begin charging you the full interest rate. Moreover, whatever balance is left over at the end of the bonus period will also be assessed at the full rate from that point forward. Consequently, if you either slip up and miss a payment, or accidentally leave the bulk of the balance on the card after the signup period expires, the resulting interest rate charges are quickly going to wipe out your meager gains from the scheme.
In theory, you can avoid these problems simply by being very careful about keeping up with your obligations on time. However, in order for credit card arbitrage to work, you will need to operate several credit cards simultaneously, all with continuously shifting payment schedules, and just a single mistake here and there can be enough to eliminate most or all of your profits. It’s worth taking the time to think objectively about whether you can maintain that sort of juggling act. If not, you’re better off not playing with fire to begin with.
Another nasty problem to be very cautious with are the fees associated with balance transfers. Credit card companies are not foolish: they’re aware that people can exploit the system, even if they generally tolerate a small fraction of people doing so anyways. One check that some credit cards build in to prevent credit card arbitrage comes in the form of transfer fees, which often hold back a small cut (say, 2%) of the transfer as a penalty for taking out money as cash instead of in the form of purchases. If your new credit card comes with a transfer fee, then you’ll lose most or all of what you would have gained in interest, even if you make every monthly payment on schedule.
– Credit Risk –
Even if you can meet all of your own obligations on time, eventually the banks are going to catch up with your scheme. They will do this through a particularly devilish device known as your credit score.
Credit ratings are at the core of today’s debt-based economy. The major credit rating agencies take in confidential information from all directions, maintaining files that track all of your available credit (including credit cards), current debts like mortgages, and all of the problems you’ve had with credit in the past several years, like late payments, defaults, and – worst of all – bankruptcy. Then they share all of this information with financial institutions whenever you fill out an application. The more black marks in your file, the lower your credit score will be – and the less willing the bank will be to give you easy access to credit.
Unfortunately for you, loading up on massive amounts of temporary credit is a fast way of piling up warning signs in your credit file – and, as a result, lowering your credit score. Banks looking at the file will be more likely to conclude that you are either (a) grotesquely overspending and drowning in debt, or (b) deliberately manipulating the system through arbitrage. You can try and clear up your file by canceling credit cards once the free interest period expires, but that results in a knock to your credit score, too. In any case, they’ll usually be happy to lend you more money, but only at higher interest rates. The reason is quite simple: using the credit rating information, they’ve identified you as a risky borrower.