Key Takeaways
- A crypto-backed loan allows you to access cash or crypto with no credit score and lower interest fees. You can invest or spend using cryptocurrency as collateral.
- While borrowing against crypto is inherently risky since margin could happen when an asset’s price falls, lenders offer relatively higher APYs than traditional banks.
- A crypto lending platform is the intermediary between lenders and borrowers, and crypto loans are available from both centralized and decentralized platforms.
Crypto-backed loans are disrupting the regular loan market by rewriting the rules on lending and borrowing. If you’re thinking about taking up a crypto loan, it’s important to learn more about such loans. This guide discusses the subject of borrowing against crypto so you can decide whether it’s a venture you’d like to explore.
For anyone new to the crypto space, the term crypto-backed loan may need some clarification. This is especially true for digital asset diehards with crypto holdings they have amassed over time and are growing in value. On the other hand, there are a few users who have learned about the concept of Bitcoin-backed loans who question the wisdom of accumulating wealth on the blockchain and failing to take advantage of existing money-making opportunities.
The truth is a new crop of crypto-millionaires have taken advantage of the existence of borrowing against crypto without ever selling a single digital asset. Several DeFi (Decentralized Finance) platforms are offering loans to HODLers willing to set their cryptocurrency as collateral and gain some interest. Cryptocurrency-backed loans are similar in structure to your specific security-backed loan, allowing you to access your crypto wealth.
What is a Crypto-Backed Loan?
A crypto-backed loan is in every way comparable to a traditional security-backed loan, where digital asset holders can borrow money for use or investment. However, since cryptocurrencies operate slightly differently from traditional fiat currencies, borrowing against crypto differs in some ways from the traditional bank loan. Taking a crypto loan doesn’t require filling up lengthy forms of assessing the borrower’s credit check.
The only thing that a crypto loan platform requires for you to access the facility is collateral in terms of cryptocurrency. As long as you have a tangible crypto investment, you are as good as someone with a high credit score. Moreover, having digital assets as collateral lowers the amount of cash owed relative to the value of your crypto, meaning that you end up paying a lower interest rate.
Different crypto lenders have specific loan amounts they issue. For example, Borrowers on some platforms receive a minimum of $50 worth of stablecoin loans and up to $500 in fiat currency loans. Similarly, crypto-backed loan platforms have prescribed maximum loan amounts besides the maximum loan-to-value (LTV) rations they offer. In most cases, though, a maximum LTV of 50% of your loan collateral is mostly offered by many lenders. Nonetheless, a few select platforms are offering up to 90% LTV of collateral value to borrowers.
In many such cases, though, the catch for such enticing deals is usually higher interest rates for the crypto-backed loans. If, for any reason, you’re unable to repay on time after borrowing against crypto, the lender has significant leverage. Moreover, the volatility generally experienced in the cryptocurrency market demands that borrowers place collateral that’s worth much more than their loan amount. That way, the lender is always sure that the deal remains in their favor, whatever happens to the crypto-backed loan.
When the loan-to-value ratio is high, you may want to choose a shorter time to repay the loan. When you shorten the time, the lender may not be seriously affected by the risks associated with market volatility. It’s, therefore, essential for you to seek good investment advice when evaluating your loan-to-value ratio and whether or not you want to borrow against crypto.
How Does Borrowing Against Crypto Work?
There are two types of crypto-backed loans, namely:
Custodial CeFi (Centralized Finance) Loans
For these loans, a central authority keeps the crypto collateral and its private keys. Borrowers can’t access their collateralized coins until they finish paying off their loan amounts. While most crypto lenders are in this category, matters are changing quickly.
Non-Custodial DeFi (Decentralized Finance Loans)
Unlike the former, the platforms offering this type of crypto-backed loan rely on Ethereum-based or other related smart contracts. Smart contracts are automated agreements that self-execute once the predetermined conditions have been met. The borrower remains in charge of their collateral even though they can’t use it for anything else until the loan is paid off.
The first step in taking out a crypto-backed loan is signing up on the DeFi platform of your choice and choosing your desired loan amount. The platform will calculate the cryptocurrency you need as collateral, which you must deposit in a smart contract. The platform will match you with the right lender, and once the loan is approved, you’ll receive your cash in the chosen denomination.
Once you offer you’ve received the fiat loan, you can put the money to use and repay the loan with some interest according to the designated loan terms. Unlike traditional lending systems, DeFi platforms don’t penalize you for paying off the loan beforehand. However, the lender can cash out or liquidate your collateral if you fail to repay the loan.
The smart contract automatically returns your collateral once you finish paying off your crypto-backed loan. DeFi platforms offer relatively low annual percentage rates and high minimum loan amounts compared to traditional lenders. Crypto-backed loans make sense if you want to liquidate a lot of cryptocurrency without ever selling them.
The Benefits of Borrowing Against Crypto
Borrowing against crypto is good for several reasons. While it surpasses the traditional borrowing options in different aspects, we can only mention a few of the benefits of crypto-backed loans:
Credit Checks
You don’t have to undergo the traditional credit check before qualifying for crypto loans. DeFi platforms have customized ways to check suitability, meaning you could still be eligible for a loan even when your credit history isn’t the best. Your credit history notwithstanding, you will almost always qualify for a lower interest with cryptocurrency than the conventional personal loan.
Your Assets are Secure
Borrowing against crypto lets you liquidate your assets without locking yourself out of the crypto market. As long as you keep your end of the bargain, your digital assets remain intact during the loan period. Since you don’t have to sell your collateral, there are all chances that the value of your collateralized cryptocurrency could have increased by the time you receive it back.
Instant Funding
Occasionally, cryptocurrency loans are distributed almost immediately—nothing works better when borrowing due to an emergency. This is unlike traditional lenders, who sometimes need several days to get the money you’re borrowing.
Things to Consider When Taking Crypto-Backed Loans
We’ve already seen several clear benefits of borrowing against crypto. Nonetheless, due to the nature of crypto loans, there are essential things you need to keep in mind, including:
Margin Calls
Margin calls happen in the unfortunate event that the value of your collateral goes well below a given threshold. In such cases, the lender could ask that you increase your collateral to maintain your loan. In the worst-case scenario, the lender could sell a portion of your collateral to reduce your loan-to-value ratio.
Access to Your Assets
You can only use your digital assets to trade or transact if you still have an outstanding loan amount.
Repayment Terms
Crypto-backed loans function like traditional loans, and how much they cost depends on the DeFi platform you select. Be careful to choose a repayment schedule you’re comfortable with and can afford.
Eligible Digital Assets
The applicable digital assets depend upon particular crypto lending platforms. Depending on what you choose, you could be required to exchange your cryptocurrency before becoming eligible.
The Status of the Platform
While it’s always important to use well-established digital lending platforms, also take the time to read the fine print to avoid dealing with catastrophes later.
Conclusion
Borrowing against crypto may still be a new practice, but as cryptocurrencies go mainstream, you can be sure it will get better. Crypto-backed loans are an alternative if you have crypto holdings you don’t want to sell yet. Whatever you take crypto-backed loans for, ensure you repay your loan on time. Borrowing against crypto is an excellent idea for disciplined borrowers since diligent repayments will help to boost your credit score. What’s more, you can enhance the security of your digital assets by choosing established and secure crypto wallets that will keep them far from any online risks.
