How Crypto Lending Works

We demystify the process of crypto lending and offer some insight into the best options for lending your crypto assets for the best returns.

Crypto lending is a complex area, but one can understand it by breaking it down into its component parts. Crypto lending platforms provide a service that holders of crypto assets can benefit from. However, it's not immediately apparent to lenders what they're making their money from. Here, we hope to demystify the process of crypto lending and offer some insight into the best options for lending your crypto assets for the best returns.

The principle of crypto lending accounts is similar to that of your regular savings account. You deposit Bitcoin, Ethereum, or other altcoins and earn interest on your digital assets. The main difference is that crypto savings accounts have a higher return rate than traditional savings account rates. Some crypto interest accounts offer compound interest with weekly payouts to users’ wallets, who can withdraw funds at any time.

There are several differences between the two; the following are some things that set them apart.

What is a crypto lending platform?

Besides serving as an intermediary between borrowers and lenders, crypto lending platforms empower the borrower, the lender, and themselves. The platform enables individuals to unlock the value of their crypto assets by allowing them to earn interest through lending. These lenders' interest rates are usually better than any traditional institution's offers.

As for the borrowers, without going through a credit check, the crypto lending platform offers them the opportunity to secure loans at a proportion to the security provided. Borrowers get to use these funds to fill essential needs without liquidating their crypto assets.

There are numerous platforms out there that offer similar and different services. Crypto lending platforms make money for themselves through interest rates on loans, fees, and investments.

Insurance

Unlike most U.S. bank accounts covered by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000, crypto earning accounts are generally not covered. FDIC insurance doesn’t cover digital assets like Bitcoin and Ethereum or fiat-pegged stablecoins, meaning that the insurer may not necessarily cover any loss of funds.

However, all is not lost since several crypto interest account platforms are now secured via private insurance, with many insurers already launching services around the custody of funds. Nexo and BlockFi are among the leading crypto savings platforms with insurance cover. This insurance would cover some losses in the unfortunate event that something went wrong.

Access

Theoretically, a crypto interest-earning account works like a traditional savings account. You deposit your digital assets with no deposit limits or lock-up period. And just like your standard bank, they do business with your funds, lending it out to borrowers on your behalf for interest. Once the borrower pays back, you earn an income.

However, it’s worth noting that compared to traditional banks that pay you up to a maximum of 0.7% annual percentage yield (APY), crypto platforms pay rates well beyond 10.5% on your crypto deposits. And what’s more, your crypto deposits automatically earn compound interest at the end of each month. As you can already see, crypto savings accounts offer better yields. The amounts may vary depending on the platform you choose, the digital currency involved, and the timing. Several cryptocurrency-based platforms actually offer double-digit returns. Think of the differences as a tradeoff between risk and reward.

Yields

The yield you can earn from digital assets can be relatively high. For example, the rates at BlockFi can begin at 0.10% to 7.5% on its website, while CoinLoan offers yields of up to 12.3%. In contrast, the best high-yield savings accounts offer rates of about 0.50% APY, with the national average being around 0.06%.

Another difference, though, is that you can easily estimate the amount of interest you’re likely to earn in one year if rates don’t change with your regular savings account. However, when you’re dealing with crypto firms and juggling different crypto assets with varying volatility levels, it’s not easy to estimate what amount you’re likely to earn. That’s why it’s essential to familiarize yourself with these two types of digital assets:

  • There are native cryptocurrencies like Bitcoin and Ethereum, whose value fluctuates daily.

  • There are stablecoins like USDC and USDT, whose value is pegged to dollars or other assets.

Withdrawal Fees and Limits

Stay on the lookout for applicable withdrawal fees on different platforms that may vary and could be listed in crypto. Other platforms offer varying minimum and maximum withdrawal limits. Depending on the platform that you choose, there are two types of access:

  • Flexible access with no constraints whatsoever on withdrawal.

  • Fixed terms require an agreement regarding how long you must leave your funds untouched; the fixed-term accounts resemble certificates of deposit, which are savings accounts where your funds get locked up for a specified period in return for higher interest rates.

The cryptocurrency market isn’t like the stock market that opens and closes at set times; cryptocurrencies are accessible for buying, selling, and trading 24/7. Top crypto interest platforms deliver high crypto interest rates because they lend their digital assets to individuals, institutions, and corporations to use in their business functions. Once the borrowers repay the crypto with high interest, your platform takes a small percentage of the interest and sends the rest to your account.

How Do Crypto Lending Pools Work?

Crypto lending pools allow lending platforms to capitalize on existing crypto assets without owning them outright. A depositor puts their digital assets into the platform, then pools them together and lends them to borrowers. Crypto lending pools offer several different types of loans, including:

  • Flash Loans: These loans don't require the borrower to stake any assets as collateral. They are usually completed and repaid before the last block of the chain has been written, essentially lending assets and recovering them without changing ownership of the chain.

  • Collateralized Loans: In these crypto loans, a borrower stakes crypto assets to obtain the loan. During the period of the crypto loan, the borrower can not withdraw or access their collateralized assets. The crypto lending platforms stipulate a particular asset value that borrowers can access based on their deposits. This is known as the loan-to-value ratio (LTV ratio). The LTV ratio is typically 50% in most lending platforms, meaning that the depositor can only borrow half of the total value deposited.

  • Margin Trading/Leverage: Occasionally, some borrowers take their loan amount and reinvest it in a trading platform to earn more interest payments from their loans. This type of trading is a risky endeavor, and if the value of their initial deposit drops too far, they may face a margin call, where their assets are liquidated and the value returned to the lenders.

How is Interest Calculated on Crypto?

Most crypto lending platforms have competitive interest rates. Their rates are much better than those offered by traditional financial institutions. A bank account, for example, only generates a fraction of a percent in interest over a year. A crypto savings account can generate a lot more than that. What's more, these accounts may also pay in compounded interest.

Simple interest calculations on crypto utilize the formula:

I = P x R x T
where I = Interest Generated
P = Principal
R = Interest Rates
T = Time

These simple interest calculations are typically done over a year.

The other type of interest that a crypto savings account might offer is compound interest. With compound interest, the calculation is somewhat different:

A = P(1 + r/n)^nt
where A = final amount
P = Principal/Initial Deposit
r = interest rates
n = number of times compounded over the period
t = number of time periods elapsed since deposit

Over a short period, simple and compound interest don't have much difference in yield. However, the difference can be substantial over a much more extended period of time.

Learn more about how interest is calculated on crypto.

How to Lend Crypto and Earn Interest

Getting started with crypto lending is simple for those who already have digital assets. Lending crypto is just a matter of finding a lending platform and depositing your assets into their savings accounts. From there, the lending platform does the rest of the lending process and pays you back in crypto interest.

If you don't have digital assets, you will need to trade some of your fiat funds for crypto coins that you can deposit into the lending platform. Once deposited, they can also be used as collateral for secured loans, if you prefer. Ideally, you'd simply deposit your funds and wait for the loan repayment from the borrower, stockpiling your interest over time.

APR and APY

Crypto savings don't typically mention either simple or compound interest. Instead, the terms "Annual Percentage Yield" (APY) and "Annual Percentage Rate" (APR) are used. The annual percentage rate is the interest rate applied to a principal over the course of a year. Conversely, the annual percentage yield is the interest rate plus the compound interest on the deposit. While the terms differ, many cryptocurrency platforms use them interchangeably, making it difficult to pinpoint what each term means. Generally, APY refers to compound interest rates, while APR is used to refer to loan investments.

Learn more about the differences between APR and APY.

Tax on Crypto Interest: What You Need to Know

You are subject to capital gain/loss taxes when you buy and hold an asset for investment purposes. You are also subject to income taxes when you earn crypto through mining, staking, lending, and other means.

The percentage of this tax and what constitutes a taxable event vary from location to location. It is thus vital to understand what taxable events apply in your locality and to your unique financial dealings.

Learn more about crypto interest tax.

Who Borrows Your Lent Crypto?

Several individuals and companies can leverage crypto lending to fund their pursuits. Among the borrowers that may want to borrow your digital currency are:

  • Traders: Margin traders borrow funds from platforms to increase their gains in the cryptocurrency market. These borrowers are a higher risk for the platforms since the value of their deposits may fluctuate, requiring the platform to perform a margin call if they don't deposit more digital assets to increase their LTV ratio.

  • Individuals: Some individuals use the crypto lending market to take out personal loans that they can repay later.

  • Small Businesses: Some small businesses require financing but cannot get it through traditional means. They may not be able to pass a credit check or may lack a credit history altogether. Crypto-backed loans offer a viable option for these small businesses.

How Crypto Lending has grown in the last 3 years

The crypto lending market has grown massively. Generally, the market has hit more than $10 billion since 2019.

This tremendous growth results from the ease of acquiring a crypto loan from these platforms. Unlike their traditional counterparts, loans are processed swiftly without much fuss.

Additionally, the interest rates on crypto lending accounts beat the ones offered by traditional banks. For instance, BlockFi interest accounts allow lenders to earn interest as high as 7.5% APY and give borrowers the means to borrow money at rates as low as 4.5% APR. In contrast, the best traditional banks provide users with interest rates as high as 1.25% APY.

It is obviously a no-brainer as to why people are streaming to crypto lending platforms and why crypto lending has grown rapidly in the past 3 years.

Learn more about how crypto lending has grown.

Crypto Lending Growth and You

When a sector progresses over a couple of years on a grand scale, it means something is working well. Many have benefited from joining the train early, but you can also benefit. The cryptocurrency industry is still in its nascent stage, so odds are there might be further growth in years to come.

DeFi vs. Traditional Finance

DeFi, a shortened form of Decentralized Finance, has been the rage of the financial world in this new decade. Decentralized finance refers to a new financial system built using blockchain technology. The system is governed by smart contracts, which are codes that run on the blockchain.

This new financial system consists of digital assets, protocols, decentralized applications (dApps), and smart contracts. It uses these technologies to transfer money and verify transactions. Its goal is to promote a more transparent and less restrictive financial system.

On the other hand, traditional finance is the oldest and most prevalent financial system in the world right now. It is a system where financial institutions serve as intermediaries whenever you conduct a monetary transaction.

This kind of system, though prevalent, is slow, restrictive, and not transparent. Moreover, users are at the mercy of the intermediaries as they are subjected to rigorous checks during use.

The major advantage of DeFi over TradFi (Traditional Finance) is the freedom it grants the public to conduct financial transactions cheaply, swiftly, and anonymously. Currently, the trade-off for these perks is less security.

Learn more about DeFi and Traditional Finance.

DeFi vs. TradFi vs. You

Are you team DeFi or TradFi? Irrespective of the financial system you resonate with, it's always good to have an open mind. Why not check out the perks they both have to offer and how you can utilize them for your financial benefit?

DeFi vs. CeFi

The entire blockchain and cryptocurrency industry is divided into two sectors: Centralized Finance (CeFi) and Decentralized Finance (DeFi). DeFi has been explained in the previous section.

While DeFi aims to eliminate central intermediaries in financial processes, CeFi, on the other hand, refers to crypto-related services offered by a centralized intermediary. It's similar to traditional finance because a central entity provides financial services to users.

So we can say centralized finance is an intersection of the traditional and decentralized finance worlds.

Lending is an essential service in traditional finance. Many people utilize this to achieve their financial goals, although they have to endure complications such as credit checks, KYC, and many other imposing practices.

Learn more about how DeFi compares with CeFi.

DeFi vs. CeFi vs. You

With CeFi and DeFi, you get to enjoy these lending services without experiencing the restrictions peculiar to traditional finance.

It is important, though, for you to weigh your decision on which platforms you want to enjoy crypto lending with.

Crypto Lending

Crypto lending is a viable way for an individual with crypto holdings to earn interest. With the right crypto lending platform, a holder could earn significant interest through crypto-backed lending. While there are risks to lending crypto, many platforms ensure that their lenders are protected since they require the borrowers to secure their loans. Maximizing your earnings requires looking at what the platforms offer and choosing a savings account with the best returns.