Much has been written about arbitraging 0% balance transfer deals offered by credit cards. While 0% balance transfer deals have been used to entice consumers to applying for a new card, some savvy consumers have long used these deals to make “free money”. Here is how this exactly works.

First, let’s make a few assumptions.

1. You do a balance transfer of $10,000 (for easy computation purposes).

2. You can take this amount and put it in a bank account that earns 4.5%.

3. The balance transfer deal is for 12 months (or 1 year).

4. Let us further assume that there are no balance transfer fees.

Firstly, if you take $10,000 for the credit card issuer and put it in a bank account (fixed deposit?) for 1 year earning 4.5%, you will receive $450 after one year. Assuming that your tax bracket is 30%, then you get $315.

For the balance transfer, you have to pay 4% of your balance transfer amount to maintain the 0% deal. Hence, during the first month, you pay back the credit card issuer $400 (0.04 X $10,000). After the first month, the remaining balance is $9,600 and you have to pay 4% of $9,600, which is $384. Below is the table illustrating the cash flows.

Balance Transfer——>Payment (4%)—->Month
$10,000——————–>$400 ——————>1
$9,600 ———————>$384 ——————>2
$9,216 ———————>$368.64————–>3
$8,847.36—————–>$353.89————–>4
$8,493.47—————–>$339.74————–>5
$8,153.73—————–>$326.15————–>6
$7,827.58—————–>$313.10————–>7
$7,514.47—————–>$300.58————–>8
$7,213.90—————–>$288.56————–>9
$6,925.34—————–>$277.01————–>10
$6,648.33—————–>$265.93————–>11
$6,382.39—————–>$255.30————–>12

Total Minimum Payments made over one year is $3,872.90.

At the end of one year, you get $10,450 from the bank (principal plus 4.5% interest). You will then use $10,000 to pay off your remaining balance (actually, your remaining balance is $6,127.10 and $3,872.90 is the amount that you keep and is the amount that you paid on your minimum balance over the year).

Hence, $450 in your pocket, which is essentially risk-free arbitrage. This figure will be less depending on your tax bracket. It will also be less if you are charged a balance transfer fee. Your return on capital is infinite as there is theoretically zero financing cost and zero capital outlays if we look at the picture at the end of one year. But in reality, you need to pay the 4% minimum balance every month and your net cash flow is negative for one year until you withdraw the original principal and interest from the bank account.

However, for this to work, you have to bear a few things in mind.

1. Some credit cards only allow you to do a “proper balance” from another “higher rate credit card”. You need to find a credit card that will write you a balance transfer check or advance check.

2. You will have to pay on time and not miss a single payment. If this happens, your apr will go from 0% to either normal or default rate (very high). If you miss a payment to any other creditor and it is reported in your credit report, the universal default clause can be used by the credit card issuer to cease your 0% deal.

3. You cannot pull this off too often as there is a limit on the number of credit cards you can apply in a short period.

4. Under most terms and conditions, credit cards have the right to raise the apr from 0% to whatever they please without explanation.

Frankly speaking, for just a couple of hundred dollars and the hassle you have to go through, I would not even bother with this. Having said that, for those with quite a bit of credit card debt but still have a good credit score, getting a credit card with a 0% balance transfer deal makes sense as it reduces your interest cost quite a bit. You should then use the savings from the 0% deal and pay off the card with the highest interest rate.

My final thoughts are that 0% balance transfer deals should be used by those who want to reduce their credit card debt and still have good credit. Playing the arbitrage is just too much of a hassle for a couple of hundred bucks.

This entry was posted on Monday, December 4th, 2006 at 10:02 am and is filed under Tips and Advice, Tutorials. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.