Credit Cards and Investing

We are all sometimes guilty of making false assumptions. One of mine has been that people know better than to use a credit card to buy an investment. Yes, I can understand the need to leverage a credit card in the short-term to help fund education or business equipment in a pinch. But buying stocks or something like bitcoin with your credit card? It turns out this has been more common than I thought.

As bitcoin was riding high last Fall and making national news, retail, or "small" investors started jumping on the bandwagon. And as is often the case, these investors wanted to get in on the growth of "crypto" at whatever cost. Just think about the potential thought process: What would you pay for an investment you knew was going to skyrocket in the coming weeks and months? If you didn't have the cash to invest, why wouldn't you put in on your credit card, or even take out a cash advance, and just pay it back after the investment soars? It's a win-win can't lose proposition, right?

Enabling this at the time were credit card companies, online brokerages, and "currency exchange" websites such as Coinbase. Investors could buy once or even establish recurring purchases, all using their credit card. Most major credit cards companies allowed this, except for Discover, which said no back in 2015.

Apparently, an unfortunate number of people did this as bitcoin and other cryptocurrencies rose in value. Most of these folks probably felt like geniuses, at least for a few weeks. Then, as prices began to fall precipitously into the New Year, many of these folks realized they now owed more to their credit card companies than their bitcoin was worth, plus interest.

According to a Wall Street Journal survey, roughly 18% of bitcoin investors used a credit card to buy the currency and 22% of these folks said they'd be carrying the balance on their card, presumably until the investment recovers. Perhaps it eventually will, allowing these late investors to turn a profit, or just get back to even. Until then, however, these folks are in a tough spot.

The problem with doing all of this on a credit card is that the interest expense and other fees make it harder for the investment to be profitable. It would be like running a foot race while wearing weights. The heavier the weight, the harder you'd have to work for the same result. According to creditcards.com, the average interest rate on credit cards in 2017 was 15.6%. The average cash advance rate was 24%. Additionally, websites and other vendors typically charge a several percent (3-4% is common) "convenience fee" on credit card transactions.

This leads to an arithmetic problem that plagues many who carry credit card debt, not just cash-strapped irrationally exuberant investors. If you borrow money to buy an investment and it costs you 15% per year to carry the debt, plus a 3% transaction fee, you're already in the red 18% before you even start. If you took out a cash advance, then maybe you're in the hole by 27%. Now, assuming your investment earns more than that, you're in the black. But what if it doesn't? Do you really want to be stuck paying hefty interest on a losing investment?

Making matters worse, if you can't afford to buy an investment with cash, you likely have other credit card debt accruing interest as well. Most credit card companies apply the minimum payments you make to the lowest interest rate balances first, so that expensive cash advance might linger there until you can make payments over your required minimum. If you go a couple of years carrying that kind of debt, well, you can do the math.

Apparently, this situation got bad enough that the Securities and Exchange Commission (SEC) put out an investor alert a few days ago trying to educate investors about the risks of using credit cards to invest. Also, earlier this month major banks like BofA, JPMorgan, and Citi shut the door on using their credit cards for cryptocurrency purchases. Coinbase isn't offering to set up new credit card accounts anymore either.

It seems like the damage was done and the large banks are trying to limit their exposure. Unfortunately, that does nothing to help retail investors who now must make interest payments on a losing investment.

If you want to invest in anything highly speculative like bitcoin, first pay off your credit card balances (all of them), don't run them back up, and then create a small account (funded with cash) you can use but afford to lose. Paying off your credit cards offers a guaranteed rate of return, something investing in bitcoin or even a high-quality stock, doesn't.

Here's the SEC's alert if you're interested:

https://www.sec.gov/oiea/investor-alerts-and-bulletins/ia_riskycombination

Have questions? Ask me. I can help.