Arbitrage– the process of exploiting differences in the price of an asset by simultaneously buying and selling it. In the process the arbitrageur pockets a return.
That Sounds Too Perfect
“Free money.” Who doesn’t like the sound of that? What if I told you that millions of us will effectively give up this “free money” at least once, and probably many times throughout our lives?
Let Me Be More Clear
As you just learned, arbitrage is the process of exploiting differences in the price of an asset by simultaneously buying and selling it. Sounds pretty complicated, like something that should be left to those finance guys on Wall Street.
The asset you can arbitrage is money itself, and no, it is not very complicated.
Allow Me To Explain
Throughout your lifetime you will likely at some point acquire money at a price. As you probably know, this unearned money is referred to as debt. Debt comes in many forms: credit card debt, personal loans, student loans, auto loans, and mortgages are some common forms of debt.
The “price” you acquired this money (principal) for is the interest that you pay (APR).
So Where’s The Free Money?
I’m getting there.
Now that you have acquired the money at a price it is time to turn around and “sell” the money for a price. You may be wondering “how the heck do I sell money?” In fact, you already know selling money by another name: investing.
To put it in simple terms: If you can make a larger investment return than you are paying in interest then you my friend have found an arbitrage opportunity.
Here’s An Example
You go shopping for a new car. You’ve been crushing it on your way to a million dollars. After all, you’re part of the Let’s Be Millionaires community. So you go for this car:
Price tag is $50,000 but you’ve got more than enough in the bank so you’re ready to drop stacks (purchase something using a large amount of cash, for my readers who aren’t current with the lingo).
So here is where we are: you’ve got $50,000 cash at the ready and you have two options:
Option 1: Hand the dealer your $50,000 and be done with it.
Option 2: Take out an auto loan. The better your credit, the more opportunity for arbitrage (see “How Much Can Bad Credit Cost You?” for another viewpoint of this). You’ve been following this blog and your credit is in excellent shape so you are offered a 3% interest rate.
If you took option 1 then end of story. If you took option 2 then this is where the magic happens. You still have that briefcase of cash to go invest in whatever you please. For simplicity’s sake lets say you earn the average stock market return of 10% on your investment, or $5,000. Throughout the year you made your monthly payments which included 3% interest, or $1,500. You now have $3,500 more than everyone who took option 1.
Not So Complicated After All
Hopefully now you see that capitalizing on arbitrage opportunities in your personal life really isn’t that hard, you just have to know how to find them.
Remember the rule of thumb: if you can earn more through investing than you pay in interest then you have found an arbitrage opportunity. This means that a few forms of debt, such as credit card debt, are virtually impossible to arbitrage and should be avoided or paid off as soon as possible.
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