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5 'deadly' dangers of credit card arbitrage

By Daniel Workman

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Credit card arbitrage - the practice of using borrowed money to generate investment profits - is not for the faint of heart. It's a high-stakes game that can land you in a heap of debt very quickly if you don't play the game strictly by the rules.

Credit card arbitrage means using money from zero per cent credit card balance transfers or low introductory rate offers to buy an investment at a low price, and then quickly selling the investment for profit. debt-trap

When asked about the feasibility of using credit card arbitrage to make money on blue-chip equities, Canadian dividend expert Tom Connolly says, "I do not think leverage and high-quality dividend stocks go together." Publisher of a well-respected newsletter on Canada's top dividend shares since 1981, Connolly adds that, "Dividend income and equity gains from dividend increases only happen over long periods of time." uncovered five potentially fatal dangers in pursuing profits through credit card arbitrage.

Deadly danger no. 1: Overburdened with work
When we tweeted "The Wealthy Barber" David Chilton for his thoughts about credit card arbitrage, Chilton acknowledged that the technique was popular in the U.S. before 2008 when there were a lot more deals available. He says that many people overestimate the potential of profiting from what they see as free money. when they don't do the detailed research and time commitment required. It takes "lots of work!" he said.

Realistically, returns can be modest. Consider a credit card arbitrager who safely invests proceeds from a $10,000 balance transfer, interest-free for 10 months in a daily savings account. Given that the highest savings interest rate is currently about 2 per cent and assuming a 1 per cent administration fee of $100, the total pre-tax profit for all that work amounts to just $51.

Deadly danger no. 2: Speculative returns vaporize
Day traders argue that they can easily earn at least 10 per cent with the $10,000 in balance transfer cash, or an estimated $776 in pre-tax earnings. While that figure represents a respectable rate of return, most financial advisors agree that stock market investments only make sense over at least five years, which is generally long enough to compensate for any economic downturns that might occur.

In her book "Count on Yourself: Take Care of Your Money," personal finance expert Alison Griffiths advises that focusing on a small number of investments is a recipe for disaster. "It is extremely dangerous to invest in only a handful of stocks or follow the latest hot tip," writes Griffiths. Unpredictable investment losses can block you from repaying your credit card deal while favourable teaser rates are still in effect.

Deadly danger no. 3: Racking up penalty fees
To be successful at credit card arbitrage, investors must be exceptionally detail-minded yet nimble, and unfailingly meet payment deadlines. Missing one due date can result in myriad credit card fees that boost your debt by hundreds or even thousands of dollars.

Arbitragers must have good or excellent credit, own little or no existing credit card debt and generate a steady cash flow to cover their monthly bills. You must also pay strict attention to the credit card offer's details, promotion end dates and read the cardholder agreement's fine print carefully.

Deadly danger no. 4: Credit score crunch
Relying on credit card specials to borrow investment funds can acutely impact your credit score, especially when your credit rating is already low. Each application for a new borrowing results in a hard inquiry that depresses a credit score by up to five points. Applying for multiple low-cost offers can snowball the number of hits to your credit report, making it difficult for you to qualify for good mortgage or personal loan rates.

Even more damaging is when a high proportion of credit is used in relation to the account maximum, also called the balance-to-limit ratio. If the $10,000 borrowing represents a significant chunk of your available credit, that elevated ratio can push down your credit score.

Deadly danger no. 5: High APR debt enduring for decades
If you don't fully repay the borrowed amount before the special offer's end date, then the credit card's regular terms and conditions apply. Many cards charge annual interest rates of 19.99 per cent or more.

Based on the Financial Consumer Agency of Canada's credit card payment calculator tool, a $10,000 debt at 19.99 per cent requires 25 years and 3 months to repay when only minimum payments are made. The interest cost is similarly nasty, resulting in $12,226.88 in extra charges.

For Canadian dividend-stock guru Tom Connolly, who had thought he had heard it all before our email inquiry, credit card arbitrage is an investment approach with potentially disastrous results. "Deadly danger says it all," summarizes Connolly.

See related: 6 tips for a successful balance transfer; Editor's Choice: The best balance transfer cards 2011

Published: April 6, 2012