Balance Transfer Arbitrage

Universal default is a term that only recently came into vogue and it’s a big “gotcha” for balance transfer arbitragers because of it’s far reaching effect. If your card has a universal default clause, it means that if you are late on any of your payments to any other creditor and it is reported, they can immediately increase your interest rate without the typical grace period. Credit cards can already increase your rate arbitrarily but they have to warn you in advance and give you a period of time, 30 to 60 days, to react. With universal default, this can happen immediately (since it’s not a material change to your contract, it’s merely a clause that gets activated).

Universal default has to be a clause in your terms & conditions in order for this to apply and only a few card issuers have them as a standard. Recently (over the years I should say) there had been a lot of pressure for issuers to drop the practice and several of them agreed to.

• Discover, Chase, and American Express had UD clauses removed from T&C’s back in 2005 according to USA Today.
• Citi announced they’d be dropping UD, after making it optional (???), on 01 March 2007.

If you can get a no fee 0% balance transfer, every single arbitrage play is worth it because the money you’re getting is free. What about when the interest rate is above 0% or if the 0% balance transfer has a fee? That’s when you need to start doing some math and seeing whether all the time will be worth it. Let’s take each scenario separately and see what you need to do to evaluate the suitability of the offer.

In the analysis below, I’ll be using a lot of math rounding that you’ll recognize if you’ve done this before. I do this out of simplicity’s sake and recognize that the amounts I quote as you being able to “earn” is really a ceiling value. When you take out a balance transfer for $5,000 for 12 months, you will be paying down that balance every single month by your minimum payment. Calculating your earnings for the year on that $5,000 isn’t as simple as multiplying it by 5%, you should treat it as 12 separate calculations as you pay down the debt. Again, I recognize this and take the simple route simply because it’s good enough for our purposes. So, when I say you’re earning $50, I really mean that you’re earning something less than that.

Balance Transfer Fee
First, you need to evaluate how much of a fee there is on your 0% balance transfer. Most cards will have a 3% balance transfer fee with a minimum and maximum fee. Some cards will not have a maximum fee. In the case where you don’t have a maximum fee, then you’re basically earning the difference between your bank’s interest rate and the fee percentage, minus your taxes. So, if you can get 5% from your bank, pay a 3% fee, and you’re in the 25% marginal tax bracket, that’s 1.5% earnings for you. That means if you get a $5,000 credit limit, you’re talking about earning $75 for your trouble versus $250 if there were no fee.

Let’s say that the card has a maximum fee of $75 (a very popular one), well then it’s effectively 3% if you have a credit limit under $2,500. If you think you can get a credit limit above $2,500, then that drops your effective debt interest rate. If you get a credit limit of $5,000, pay a $75 transfer fee, then you’re really paying a 1.5% balance transfer fee.

Higher Than 0% APR
This is analogous to having a fee except it’s extracted each month instead of right off the top. Since we’re simplifying the math, it’s really just like the balance transfer fee scenario. In reality, you earn more money from an offer that has a higher than X% APR than an offer of 0% APR and a X% balance transfer fee.

I hope that helps you in understanding how to evaluate the various balance transfer offers out there.

The idea of a balance transfer arbitrage seems like a win-win proposition right? You get a cheap, if not 0% interest, loan and then deposit it in a bank where you can earn more than 0%, sometimes much more (like over 4%). Borrow money low, lend money out high, and your borrower is 100% guaranteed by the FDIC. Are there any risks? The answer is Yes, but most of those are the borrowers fault, not the environment.

Risk 1: You Get Greedy
Sometimes 4% isn’t enough and people decide that they’ll put it in the stock market or into a mutual fund. Or they bet on something with the funds, just anything that isn’t 100% guaranteed like a savings account. This is the number one reason why the balance transfer arbitrage backfires and when it backfires in this way, it backfires supremely. When that promotional interest period ends, the interest that comes on afterwards is like a firestorm. Trying to pay back thousands of dollars with a double digit interest rate is really really hard and it’s made worse by the fact that you have nothing to show for it. This is the number one risk and if you are able to take the guaranteed winnings and go home, then balance transfer arbitrage is for you. If you can’t, do not do this play.

Risk 2: You Get Sloppy
If you miss a payment, expect your interest rate to go up to the regular double digit interest rate. If you forget when your promotional period ends, you’ll probably get dinged for a month’s interest before you scramble to pay it back. While neither one of those things is a major deal killer, they do cut into your earnings significantly. Miss the first payment? Consider yourself having just wasted your time and a perfectly good arbitrage opportunity. Miss the final payoff? You lose a little of your earned money, no biggie. These are not as bad as Risk 1.

Risk 3: Your Credit Score Is Important
If you’re going to make a major purchase on credit in the near future, I wouldn’t do the balance transfer arbitrage because you’ll be opening up a lot of new lines of credit, increasing the amount of credit you have, increasing the amount of debt you have, and increasing your credit utilization. All this will ultimately mean that your credit score will fall and it will fall a lot. Not to worry, when you pay everything back then your credit will be perfectly fine, if not better than before. However, in the interim you will take a hit in your score which will increase the cost of loans should you need them. My personal opinion, and you can take it for what its worth, is that if you need a loan within the next year, avoid balance transfer arbitrage because the increase in interest will make your earnings seem like a drop in the ocean.

There you have them, the three main risks of a balance transfer arbitrage play. There are certainly more but those are the big three you must be aware of before you undertake this endeavor.

There are three steps to a successful balance transfer arbitrage:

1. Step 1: Apply for and be accepted for unsecured credit. In our case, this will be an unsecured credit card.
2. Step 2: Open a high yield savings account at a bank such as ING Direct.
3. Step 3: Request a balance transfer from your unsecured credit card and deposit it to your high yield savings account.

There you go, the three simple steps to balance transfer arbitrage.

Now, there are caveats that you must adhere to if you want this to be a profitable venture. Here are some basic rules to balance transfer arbitrage.

• Your interest rate for the balance transfer must be less than the interest rate of the savings account, otherwise you’ll be losing money.
• When considering balance transfer offers, you must take into account any balance transfer fees. A no fee 0% interest balance transfer is the ideal line of credit and they are plentiful, so unless you exhaust all those avenues you should be getting a no fee 0% balance transfer.
• You must not deviate from the three steps above. Do not use the credit for anything else such as a new television. Do not put the credit at risk by trying to get more in interest, such as by putting it into the stock market.
• Be diligent and remember when the balance transfer promotional interest rate will expire and pay off the debt before any interest is assessed. A month of high interest can put a significant damper on your arbitrage play.

Balance transfer arbitrage is very easy and very safe if you follow those simple rules. If you decide you want to outsmart the system, that’s when you get into trouble.