Ebook Evidence on the profitability of credit card arbitrage
Many banks offer credit card balance transactions with low, or no interest rates. The balances can generally be transferred to pay off another card or transferred directly into a checking account. These introductory low interest rate offers are intended as an enticement for individuals to open an account with the financial institution or to transfer their balance to a lower interest rate credit card.
The low interest rate offers generally apply to an introductory period and have an up-front fee. The introductory time period is typically anywhere from three months to eighteen months. Other promotions offer the introductory rate until the balance is paid off. Still other promotions offer perquisites, such as frequent flier miles, for each dollar transferred to their affiliated credit card. Some promotions require the cardholder to make a purchase to receive the special rate.
Although the credit card offers are intended to attract more credit card business for the bank, they may also provide the customer with the potential to earn an arbitrage profit. To earn an arbitrage profit, an individual takes a cash advance against the credit card and deposits the funds received into an FDIC insured money market account. An arbitrage profit is earned if the interest earned on the money market account exceeds the cost of funds related to the credit card cash transfer.
Low introductory rates serve as a loss leader for the financial institution. Banks profit from these offers in several ways. Some of the offers are made on accounts with an annual fee. In these instances, the annual fee offsets the cost of offering the introductory rate. In other instances, there are penalties for not paying the card off according to the terms of the introductory offer. In the event of a missed or late payment, the interest rate on the card reverts to the regular, much higher rate allowing the bank to earn a profit.
The offers are typically subject to a cross-default feature, whereby a default by the borrower on any of their financial obligations causes the credit card to revert to the higher, regular rate. Banks may also earn a profit if the cardholder uses the card for purchases in addition to the cash advance. The bank earns a transaction fee in these instances. These transaction fees offset the cost of providing the low introductory rate. Finally, some introductory offers, despite having an enticing appearance, are designed in such a way that arbitrage attempts will be unprofitable.
In this paper, we examine credit card arbitrage and the extent to which profits can be earned from credit card arbitrage. In addition, we consider the role of items that may potentially frustrate the arbitrage or reduce the profitability of the transaction. The remainder of the paper is organized as follows. Section 2 reviews some of the relevant literature regarding credit card operations and transactions. Section 3 provides a detailed example of a credit card arbitrage transaction. Section 4 considers the sensitivity of the profits to changes in the underlying variables of the arbitrage. Section 5 examines the impact of credit card arbitrage on credit scores. Finally, Section 6 provides concluding comments on the transaction.
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