My pal over at Chasing The Points has come up with a yet another crazy scheme for riches. Read the post here if you haven’t already: Jumping Into Debt To Manufacture Spend And Invest. We’ve met in NY a couple of times to talk blog, travel, finance, etc and I think he is one of the few innovators out there. Some of the projects that he is currently developing are very impressive indeed. I believe that when you are innovating you have to push the boundaries too far, else you will never know what you can achieve, and in this latest post, I wonder if he is pushing boundaries, or left them way behind.
The overview of the gig
- Obtain a student loan – use funds to invest in stock market.
- Deducting Taxes from Loan, and using Evolve to pay it down at 5% cash back.
- 4.3% origination fee of loan
- 6.4-7.2% APR depending on when the loan is originated.
It sounds like madness to me, but could there be a method to it? Lets look at the math and decide. For the purpose of this example I will assume a loan of $10,000 and an effective tax rate of 35% (including city and state) CTP decided to use the 7.2% APR so I will too. Here goes:
$430 origination cost
Assuming they do not amortize the fee into the loan, a 10 year repayment plan would result in:
- Monthly Payments of $117
- First Year Interest Paid of $697
- Total Interest Paid of $4,057 to 10 year term (unlikely to occur)
Student Loans are interesting… they are one of the few deductions that you can take without needing to itemize, this can be very useful, as the standard deduction is a powerful thing for many filers. In this case, in year 1 we could deduct $1,127.
It is very important to remember that a deduction is inferior to a credit when it comes to taxes. A deduction means your salary is reduced by that amount, and therefore to ballpark the value you have to multiply the deduction by your tax rate. We said 35% (arbitrarily) so the value of the deduction is $1,127*35% or $394.
What that means is total out of pocket cost is $1,127-$394 for $733
At this point, lets bring in the Amex Blue Cash, 5% cash back… this thing changes everything, the APR is meaningless in comparison. $10,000 will have a net cost of $733 in year 1, but at 4% net, you could earn $400 each month using the Blue Cash card (old style) kinda makes for an interesting equation you might think…
Here’s a problem though…
You can earn the $400 per month without getting into debt. The manufactured spending cycle is such that you can buy in and exit out of positions fast enough to pay off the bill before it hits, and pocket the profit. The deal that Chasing The Points is chasing has him not doing this, instead he is pulling the money out of the loop, and putting it into the stock market.
Is this smart? My initial reaction is hell no! But we need to think about this as not pure economics anymore, this is hyper economics – when you have opportunities to earn $400 per month from a credit card.
Got the Line, Got the float, but how can you liquidate?
The interesting aspect is the restriction to earning in Manufactured Spend is very rarely on the Line of Credit or Float side… in fact it is on the exit side. I could, in the time of Vanilla Reloads and CVS walk into a store and purchase $5,000 every day of these cards. My wife could do the same, so we could acquire $300K per month, paying fees of $2,370 and spinning off $15,118 in cash back for a net profit of $12,748.
Of course this is theoretical, and assuming that Amex didn’t get upset with us for earning $12,748 per month in profit… but it could hypothetically happen. The issue… what the hell to do with all the cards? The most obvious exit strategy was Bluebird or Serve, but only one per person means you have another $280K to liquidate each month.
Enter Evolve Money
Evolve Money is a bill pay partner of this loan – by originating it he is able to find another way to exit out his funds. Personally I never got on the Evolve bandwagon, I just don’t have the options, no debt service to make so I am kinda stuck.. which is annoying because I would like to be able to push through more money. I can see the desire to take on debt in order to open the payment pipeline. When you can earn $400 in a month it’s pretty enticing.
However- if you earn $400 in a month, then you have basically paid off that $10K loan, in two, and you are back to square one. What you have effectively done in this case is fund an investment account with a credit card. This is a neat concept, but you paid $430 and earned $400, so you got into the market for $30 of loss, plus annual APR. Of course, you can cycle the 10K many times over during a month, and generate a lot more from it than $400, but that is neither here nor there in regards to taking a loan, that is purely about credit lines and float. Alternatively you could fund the debt over the long term, with the short term inflows of Cash Back.
“Never fund long term debt with short term debt”
If you don’t have the funds capable to pay off the Student loan in month 1, then you are borrowing money to invest, this concept of leverage is nothing new, found in all manner of debts,from margin accounts to mortgages. The problem is that you have many moving pieces… if they move in the wrong way you can get trapped funding a long term position with a short term debt squeeze. Let’s run a worst case scenario, and see how bad it can be.
- Borrow $10,000, pay origination fee and incur annual interest – net cost in year 1 $733
- Evolve money stops payments to Student loan, or stops taking giftcards etc – exit route closes
- Stock market drops 20%
As you can see, despite the title doomsday, this is actually a reasonably viable, if somewhat pessimistic scenario. Anyone who is involved in the stock market should know it can easily drop by 20%. In fact I advise anyone investing in stocks to be OK with a 50% drop, else they shouldn’t be in the market.
The impact of this to net worth would be:
-$733 for loan
-$2000 for stock market loss
Or would it? Remember, one of the key points here is ‘taxes’, so the $2K loss wouldn’t be totally washed, if applied to ordinary income 35% would be reclaimed.
New total loss = $2,033 ($733+$1,300)
Or is it?
If one was disciplined, they could vow to pull the money from the market the moment that Evolve stopped being a bill pay partner – which might mean the miss the crappy stock day… so the new loss is $733
Or is it?
Well, if Evolve stops bill pay, and they pull the money out of the market, they could pay back the loan in full, meaning no annual interest payments, and the cost of the venture would be $430, which after tax could be $280.
If, then, else
There are series of outcomes that could occur – for example the stock market could keep on rising, the $10,000 could increase in value. The Evolve option may be there in perpetuity. If things start going awry if the scenarios are mapped correctly costs can be minimized. Without a doubt it is impossible to know when the market may drop 20%, so that has to be something that you are happy with. But the funny thing is, in the world of hyper economics, a 20% drop, or $2K in a month isn’t earth shattering. Due to the tax arbitrage between the Capital loss and a good month of earning in a tax free manner, the net loss on the $10K investment could be recouped in a matter of weeks.
With control, even an investment of $10K like this is actually manageable. There is downside risk, but there is upside too… as I run through the concepts and numbers I have to say I am more comfortable with the idea. However, I do happen to have one other variable that I am factoring in, I know the guy behind Chasing The Points, he is a smart cat, and he has a good job, so I think he can handle this. As a concept for people who I don’t know, I wouldn’t advise going near it.