Arbitrage is popular partly because it’s a very simple concept that can help people earn or save a lot of money. Arbitrage is when you buy something for one price knowing you can sell it for a higher price.
It’s one of the driving forces behind retail (buy wholesale for $9.95 and sell in your store for $24.99) and most manufacturing (buy $4.99 worth of supplies and assemble and sell it for $14.99). Temporal arbitrage is the core concept of investment: You put in $10 today to own something that will be worth $12 next year and $20 five years from now.
Arbitrage is also how commercial lenders make their money. A credit card charging 15% lends you $1,000, knowing they’ll get paid back more than $1,000 and keep the difference as profit. But you can also use arbitrage to help win part of the credit and debt battle.
By borrowing money at a rate you know is lower than you would pay with your current debt, you can make that debt less expensive in the long run. Here’s how…
1. Credit card balance transfer
Most credit cards let you transfer the balance from an account with a competitor to their card. So if you have one card with available credit and a lower interest rate than another, you can transfer the debt from the higher-interest card to the lower-interest one and pay less interest moving forward. Better yet, many credit cards have special offers to encourage you to do so, giving you access to even lower interest temporarily.
For example, if you have a $2,000 balance on a card at 18% interest and $2,000 of room on a card that charges 11% interest, you save 9% interest if you move that balance from the first card to the second.
Pros of this method
- Most card companies want you to add to your balance with them, so they make doing this easy.
- Ease of access. You don’t have to apply for a new loan or any other resource to reduce your interest on existing debt.
Cons of this method
- Complex terms and conditions can limit the value of a transfer.
- Low-interest rates often have a time limit.
- Even low credit card interest rates are among the highest you can get compared to all forms of credit.
- A transfer may increase the balance of your credit card to a point that negatively impacts your credit score.
Watch out for…
Balance transfer fees. Although a lot of cards offer very low-interest rates on balance transfers, that transfer often comes at the cost of a one-time fee, calculated as a percentage of the amount you transfer. In some cases, when this fee is combined with the interest rate for the card, you end up not saving any money in total.
2. Debt consolidation loans
Some companies specifically target people with high-interest debt by offering single, lower-interest loans, known as debt consolidation loans, to help them pay off this debt. These typically help consumers in two ways.
First, the lower interest makes the debt less expensive overall. Second, the loans are usually structured to be paid off in years, so the monthly minimum payment is lower than the total payments the borrower was making on multiple loans and cards. This leaves them more disposable income every month to help improve their finances overall.
For example, a family might have three credit cards with a total balance of $7,000; monthly minimum payments of $300, $175, and $75; and an average interest rate of 14%. They might get a debt consolidation loan at 8% with a monthly minimum payment of $200.
Pros of this method
- Addresses the hardships of debt along two fronts
- Frees up money to pay off other high-interest debt
- Clears credit card balances to below 30%, which can improve your credit rating overall
Cons of this method
- May require an extensive application process, which can be time-consuming and arduous
- Often requires collateral
Watch out for…
Predatory lenders. Some debt consolidation companies are the real deal and out to help people who have been caught in credit problems. Others want to milk you for all they can get. Check online resources like Ripoff Report and the Better Business Bureau before signing up for any loan.
Find the right loan to consolidate your debt.
3. Personal loan/line of credit
This option works just like a debt consolidation loan, moving debt from high-interest accounts to a single lower-interest loan. Except you meet with your bank or credit union to get your own personal loan or line of credit.
For example, you might have a car repair loan of $1,000 at 21% interest and a credit card balance of $4,000 at 18%. Getting a $6,000 personal loan or line of credit at 12% is a win.
Pros of this method
- Frees up money to pay off other high-interest debt
- Clears credit card balances to below 30%, which can improve your credit rating overall
Cons of this method
- Can be very hard to qualify for, especially if you already have bad credit due to multiple high-interest loans and cards
- Often requires collateral
Watch out for…
Punishingly high-interest rates and high setup fees. A personal line of credit often comes with higher-than-average interest when your credit is already problematic. Run the numbers to make sure it actually saves you money.
4. Home Equity Line of Credit (HELOC)
A home equity line of credit uses your house as collateral for a flexible account you can borrow from as needed. Interest rates tend to be quite low, so you can take money out of it to pay off higher-interest accounts.
For example, with $40,000 of equity available in your home, it would be relatively easy to qualify for a $10,000 line of credit at interest rates 1/4 or less than that of a credit card you might qualify for. If you had $7,000 of high-interest debt, you could borrow $7,000 against that line of credit, leaving the other $3,000 available for emergencies.
Pros of this method
- The low-interest rates of a home loan with the flexibility of a credit card
- Can be easy to qualify for with sufficient equity
- Minimum payments decrease as the balance on the HELOC goes down
Cons of this method
- Must put your house up for collateral
- Usually subject to fairly stringent income requirements to qualify
Watch out for…
Variable-interest loans. Your mortgage is most likely locked in at a specific, low-interest rate for its life. Many HELOCs have a variable interest rate, meaning the rate is recalculated periodically according to market conditions and your credit rating. If possible, get a HELOC with fixed interest. If that’s not possible, check the history of HELOCs rates from that company to confirm you still save money if rates increase.
5. Home refinance
When you refinance your home, you have the option to borrow additional money against your equity in a one time, high-value cash influx. With that cash, you can pay off your higher-interest debt. Because that debt is spread out over a mortgage’s term – often 15, 20, or 30 years – the increase in your mortgage payment is usually minuscule.
For example, if you refinance a home with $40,000 equity and pull out $20,000 cash, you can spend that money to pay off a $7,000 car loan and $8,000 in credit card debt, with $5,000 left for other projects. That $20,000 will be at a fraction of the credit card interest and cost less per month than you had been paying.
Pros of this method
- Potentially the lowest-interest debt you can get
- The low cost per month frees up disposable income to improve your finances in other ways
Cons of this method
- Must put your house up for collateral
- Qualifying for a new mortgage can be very difficult
Watch out for…
Predatory mortgage lending. Although the 2008 mortgage crisis led to regulations to make this less common, some refinance mills aim to trap people in high-cost mortgages with surprise fees. Read the documentation carefully and compare it to your existing mortgage before using this method.
6. Friends & family
If you have friends and family who (a) have extra money to lend, (b) don’t mind lending money, and (c) you’re confident a loan wouldn’t strain your relationship with them, you could ask them for a personal loan to help take the edge off your debt. In some relationships, these loans are zero-interest favors. Others charge interest, but at a much lower rate than a bank or credit card company would charge for the same kind of loan.
For example, you might owe $6,000 in credit card debt at 15% interest and borrow that money from a sibling. The sibling might lend it interest-free or ask that you pay interest equal to the yield on the money market account they would have put the money in otherwise.
Pros of this method
- Can be very low-interest
- Can set up flexible repayment plans
Cons of this method
- Stress on the relationship
Watch out for…
Miscommunication that adds stress to the relationship. Write down a plan together that includes interest due, a payment plan, and what will happen if you don’t or can’t keep up with the plan you agreed to. The more details you iron out, the less likely this is to cause a serious problem in your relationship over time.
Final thought
One last thing to watch out for that applies to all of the techniques we’ve discussed: None of them eliminate the debt you have; they just move it to new accounts. That leaves room on the old credit cards and lines of credit, which you might be tempted to use. If you do that, you don’t engage in debt arbitrage. Instead, you increase how much you owe and end up in a worse position than where you started.
If you choose to try debt arbitrage, the best practice is to either close the accounts that used to carry debt or to pretend they don’t exist. The latter can be better for your overall credit rating, but only if you succeed in not using them. If you think that’s a risk, it’s better to cancel them altogether.
Article author, Randy Holt, is a finance writer in the Midwest. He writes a number of pieces about debt management and savings tip
