Date: Mon Jan 04 2021 ; Tags: Personal Finance »»»» Credit

You look through your daily mail, and an envelope from one of your credit card companies is there. It says something like "Cardmember Account Information Enclosed". Expecting something official (because it looks official), you open it finding a solicitation to spend money, and they've conveniently enclosed some checks. You're offered a low "promotional" and "fixed" interest rate. They suggest you can take a vacation, buy new furniture or a computer, pay your bills, pay other credit card balances, or anything else. Hmmm... you think. Is it advantageous to take the offer, or not?

Well, it depends.

For example, if you're deeply in debt with lots of high rates then the promotional rate will decrease your interest cost, as covered here. Consider what you're going to use it for, and what it's going to cost you. Using a promotional rate to pay a high rate existing debt works because the interest cost on the transferred balance is lower than in the original debt.

A typical program

Let's first look over the particulars for a typical program:

• A limited time to use the program (1 month).
• Any amount, up to the credit limit.
• "Promotional 3.99% fixed APR on the attached checks until the balance is paid off".

More details you have to hunt for

• Transaction fee of 3%, minimum of $5, maximum of $50.
• They can decline to give you the money.
• The promotional rate is contingent on complying with the terms of your account. For example, keeping up with payments on time, staying under your credit limit, no bounced checks, etc.
• The "grace period" within which you may pay and avoid having interest charged does not apply to the balance associated with one of these checks.
• Any payments you make will apply first to the balance held on a promotional rate, and not to any balance held on a high rate. A tricky thing about this is that the finance charges are often not included with the low rate balance, but accumulate at a high interest rate. Due to the payment allocation scheme, the accumulated finance charges will not get paid on until you pay off the initial loan amount.

In the hard to see details, there are a number of gotchas you have to watch for. Make the slightest stumble, and the interest rate will skyrocket and your savings on interest cost going out the window. That's not to mention the up-front transaction fee.

Costs: Let's first look at the cost. As you can see, there are two forms of cost, the transaction fee, and the monthly interest. At the interest rate given, each $1000 held for a full year costs as follows

$39.90 in interest
$30 in up-front transaction fee

That adds up to $69.90, or 6.99% interest during the first year. Hum, wait a minute, they said 3.99% on the flyer didn't they? Well, that transaction fee pushes your effective interest rate up, doesn't it? Fortunately the transaction fee applies only for the first year of holding the debt, and in the second year the fee doesn't apply.

If you take a higher amount eventually the transaction fee maxes at $50, which makes the effective interest rate less. Where is this amount? Well, it's whatever amount where the 3% fee equals $50, or:

$50 / 3% = $1666.67

This means that if you took $5000 instead of $1000, your fees are:

$199.50 in interest
$50 in transaction fee

This equals $249.50 in the first year or 4.9% effective interest rate. Still higher than the 3.99% promotional rate, but better than at the $1000 level. Of course, again, in the second year the effective rate falls to 3.99% again. That is, if you want to hold the debt for that long.

Putting this to use

This is the essence of the "other peoples money" paradigm, isn't it. By borrowing some money, you get to do something for yourself. The thing is, they want to charge you a fee for using their money. In a way that's fair, but as discussed elsewhere it does costs you more than your money to do this, it costs you your life. Isn't it worth your consideration to see whether it's worth your life to have this extra money, yes?

Leverage: Using low-interest debt to create money

There is one monetary angle to this type of deal which makes some financial sense. Namely, if you take the money, and invest it. This is called leverage, taking one asset (your credit rating), using it as collatoral for a loan, and investing the borrowed money.

The leverage game works so long as the money coming in from the investment is greater than the money paid in interest on the loan. An example will make this clearer. Suppose you've borrowed the $5000 above, and invested it in something that pays 7.99% per year.

This chart makes a couple simplifications. First, I have not accounted for taxes, so you should take that yield to be the after-tax yield. Secondly it is not accounting for paying down the borrowed amount during the life of the loan. Of course you're going to make payments on the credit card aren't you? Therefore the interest cost will decrease over the period you hold the balance on your card.

This is an interesting possibility, isn't it. You can buy an investment in something simply by using the credit card companies money, and that once it's paid off you'll have an asset that pays you some income. All you have to do is find a safe investment which pays a higher amount than your interest cost. The other thing to do is make sure and fulfill every requirement put on you by the credit card company, 'lest they jack up your interest rate.

But what if you play this another way. What if, instead of borrowing money from the credit card company, you pay yourself directly. That is, by having the credit card loan you're obligating yourself to a monthly payment which impacts your available cash. Suppose you take the same impact to available cash, and instead of using it to pay this new credit card debt you just send it to the brokerage account.

Let's run the numbers on this, assuming you've chosen to pay $500 per month to yourself.

Now let's look at taking a loan of $5000, invested the same way.

Which you do is up to you, however it's clear that if you take the credit card loan the investment will end up far ahead. Of course the clincher is whether the hit on available cash can be covered.