Credit Card Arbitrage I – How Does it Work?
This is an article I first wrote back in 2007, but reposted due to changes in the financial landscape. You can now use this strategy with the TFSA to avoid paying any tax on the interest earned.
Credit card arbitrage seems to be a popular strategy to make a few bucks in the personal finance blog world. I’ve personally never done it myself, but the concept is simple enough for me to explain it and give my opinion on whether it’s worth the fuss.
What is Credit Card Arbitrage?
Credit card arbitrage is where you take a low rate balance transfer promo offer from a credit card company and invest it in something that will hopefully give you a higher return.
How Does it Work?
The beauty of this arbitrage is the simplicity.
- Apply for the credit card offering the 0% balance transfer/cash advance. (Update: March 2012 – MBNA is offering 0% for 10 months with no annual fee – offer may not last long with TD Bank acquiring MBNA)
- Once approved, write a credit card cheque to yourself and deposit it into a TFSA high interest rate savings account or GIC.
- Before the balance transfer offer expires, pay back the credit card in full.
- Note, NEVER make any purchases with the credit card as they will charge you with regular interest.
In order for it to be called arbitrage, you need to make a profit from the deal. However, in my opinion, guaranteed profit is the recommended route to take.
Here are some options:
- Place the cash in a TFSA, either a highest interest rate account or GIC. Note the TFSA contribution rules when repaying the credit card.
- Place it in a taxable high interest savings account or GIC.
- You could use the money as an interest free RRSP loan. The only issue being that you will have to make up the difference between what you owe and what you get on your tax return. Even so, your tax return will probably not get to you in time to pay back the balance, so you would have to ensure you have cash on hand to pay back the loan in full.
- If you have a used car purchase coming up, and plan to get short term financing (1 yr or less), then using a 0% card may make sense.
- Although the stock market may be an option, placing the money into the stock market for 1 year is far too risky as capital preservation is high priority in this strategy.
Note: As of August 2011, check out the smaller online banks like Outlook Financial or Achieva for the best TFSA rates. For more ideas, check out my high interest rate TFSA article.
- If the money is placed in a taxable account, interest income is taxed 100% at your marginal rate. For more info read my article about how Canadian investment taxation works. So if your marginal rate is 40%, then 40% of your interest income/profit will be taken by the government at the end of the tax year.
- The second biggest drawback of this strategy is the potential draw down of your credit score. If you borrow the maximum balance on your credit card and keep the balance for a period of time, your credit score can be affected. The solution? Only borrow half of your credit limit.
- If you withdraw from a TFSA to pay back the card, you cannot recontribute the same amount until the new Calendar year.
What’s the next step? Check out Credit Card Arbitrage II – An Analysis, I will get into the offers available to Canadians, some number crunching and final conclusions. Stay tuned!