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 idea, but one can understand it by breaking it down into parts. Here, we debunk the myths surrounding cryptocurrency lending. We will also advise you on the best ways to lend your crypto assets.
Standard crypto lending accounts operate on a similar principle as traditional savings accounts. Users transfer cryptoassets into a lending account and earn interest on deposits.
The distinction between crypto and conventional savings accounts is the higher return rate. Cryptocurrencies offer higher interest rates.
In some cases, crypto interest accounts offer compound interest. With this feature, users get weekly payouts to their wallets. Additionally, they can withdraw their funds at any time of their choosing.
What is a crypto lending platform?
A crypto lending platform is where it all goes down. It is the intermediary between borrowers and lenders. These platforms allow users to earn interest from lending. This method enables investors to unlock the value of their cryptocurrency holdings. They usually offer better rates than traditional institutions.
There are two types: CeFi and DeFi crypto lending platforms. CeFi lending platforms have a central authority and are usually regulated. They are generally more secure than their DeFi counterparts. Examples are Nexo, YouHodler, etc.
There are also DeFi lending platforms. These platforms are often unregulated and run by smart contracts. While they offer more freedom, they are more prone to hacking and other exploits. Examples are Aave, Compound, etc.
Which crypto lending platform should you go with? Here are some factors to consider:
The interest rate
How much it charges
How secure it is
The lending duration
What digital assets it supports, and
Whether it has a deposit limit.
Differences between Crypto and Traditional Savings Accounts
There are several differences between crypto and traditional savings accounts. They include the following points:
The Federal Deposit Insurance Corporation (FDIC) covers most U.S. bank accounts for up to $250,000. This insurance policy does not cover crypto-earning accounts. As a result, most lending platforms in this space can not offer this type of insurance policy to their users.
As a replacement, many private insurance companies already offer money custody services. As a result, many platforms for cryptocurrency interest accounts are now secure.
Leading crypto savings platforms with insurance protection include Nexo and YouHodler. The insurance protection on these platforms covers any losses.
A crypto interest-earning account works like a traditional savings account. Investors deposit their digital assets with no deposit limits or lock-up period.
Like traditional banks, crypto lending sites lend funds to borrowers for interest. Investors earn a part of the income when the borrower pays it back.
Traditional banks' interest rates pay up to a 0.7% annual percentage yield (APY). Crypto platforms pay rates well beyond 10.5% on investors' crypto deposits. Furthermore, such deposits earn compound interest at the end of each month.
Without a doubt, crypto savings accounts offer better yields. The amounts may vary depending on the platform an investor chooses. It will also vary based on the digital currency and timing.
Several cryptocurrency-based platforms offer double-digit returns. Think of the differences as a trade-off between risk and reward.
The yield investors can earn from digital assets is usually high. For example, YouHodler offers yields of up to 8%. In contrast, the best high-yield savings accounts offer about 0.50% APY in interest rates. Generally, the national average is around 0.06%.
Another difference is that traders can estimate the interest they will earn in one year. Cryptocurrency firms offer different crypto assets with varying volatility levels. As a result, it is not easy to estimate the amount a trader is likely to earn. Thus, traders need to familiarize themselves 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. The value of these assets links to the US dollar or other fiat currencies.
Withdrawal Fees and Limits
Stay on the lookout for applicable withdrawal fees on different platforms. The value of these fees varies according to the platform an investor selects. Other platforms offer varying withdrawal limits. Depending on the platform that a trader chooses, there are two types of access:
Flexible access with no constraints whatsoever on withdrawal.
Fixed terms specify how long an investor must keep money idle. The fixed-term accounts resemble certificates of deposit. These are savings accounts where a user's funds remain for a specified period. After that period, investors will receive interest on their deposits.
The cryptocurrency market is unlike the stock market, which opens and closes at set times. Instead, digital assets are accessible for buying, selling, and trading 24/7.
The top crypto interest platforms deliver high crypto interest rates. They can do this because they lend their digital assets to individuals. Institutions and corporations also receive and use these funds for business functions.
After borrowers repay with interest, the platforms take a percentage of the interest. Lending platforms also send the rest to the accounts of their investors.
How Do Crypto Lending Pools Work?
Crypto lending pools allow platforms to capitalize on existing crypto assets. Yet, many of these platforms do not own these assets outright.
Depositors put their cryptocurrencies onto the platform. In return, the platform pools them together and lends them to borrowers. The pool also compares different crypto lending platforms and chooses the ones that will be more lucrative for the lender. Crypto lending pools offer several different types of loans, including:
Flash Loans: Borrowers do not need to stake any assets as collateral for these loans. The types of loans are for a short period. As a result, they are dealt with and repaid before the last block of the chain reaches completion.
Collateralized Loans: To receive these loans, borrowers stake crypto assets as collateral. All collateralized assets are inaccessible during the duration of the loan. Additionally, the loan's value depends on the collateral's size. This criterion is a result of the loan-to-value ratio (LTV ratio). Generally, the LTV ratio falls at 50% on most lending platforms. Thus, depositors can only borrow half of the total value deposited.
Margin Trading/Leverage: This type of trading is prevalent among crypto traders. Borrowers take their loans and reinvest them in a trading platform. The goal is to earn more interest from their loans. This type of trading can be risky. If the value of their initial deposit drops too far, they may face a margin call. Their assets are liquidated, and the value is used to repay the lenders.
Crypto lending pools replace traditional banks in mediating the loan acquisition process. Unlike banks, though, they only take a little cut from the interest payments. Thus, lenders get rewarded with far higher interest rates. But with no central authority, how are lenders sure they will get their money back?
The answer lies in the liquidation mechanism of lending pools. These pools use smart contract oracles to track the price of their deposited assets. When the price reaches a trigger level, the pool takes action. It liquidates the borrower’s collateral to repay the loan amount. To be safe, the lending pool usually puts the trigger at a point above the collateral’s initial value.
In some cases, crypto lending pools give users some tokens after depositing. These tokens represent the shares of the users in the pooled amounts. They can also share their interest with anyone by sending them the tokens.
While crypto lending pools come with greater freedom, they also have risks. There is the general crypto risk of price inconsistency. Besides that, smart contract pools are usually not regulated. There is also the risk of impermanent loss. This sometimes reduces the value of the assets in the pool. In the end, investors are the ones who pay for the resultant price discrepancies.
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 create a lot more than that. What is more, these accounts may also pay in compounded interest.
Simple interest calculations on crypto use the formula:
I = P x R x T where I = Interest Generated P = Principal R = Interest Rates T = Time
These simple interest calculations apply to one year. A crypto savings account might also offer compound interest to investors. 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 periods elapsed since deposit
Over a short period, simple and compound interest do not have much difference in yield. Yet, the difference can be considerable over a much more extended period.
How to Lend Crypto and Earn Interest
Crypto lending is one of the best ways of earning passive income in the crypto world. It is popular because it allows you to keep your crypto assets and still earn from them. It also offers higher interest rates, usually ranging between 3-10%. You may even get more depending on what asset you lend and which platform you use.
How do you earn interest through crypto lending? Here is a step-by-step walkthrough:
Create an account with a crypto lending platform. Examples of some trustworthy platforms are YouHodler, Nexo, and CoinLoan.
After that, check the various interest rates on offer and pick the one you prefer. You may need to convert your crypto holdings to another coin that has higher rates. For example, stablecoins usually come with higher interest rates than novel cryptocurrencies. Remember, though, that interest rates may fluctuate according to market conditions.
Once you have verified your account and chosen your crypto to lend, it’s time to make your deposit. Sometimes, you can also buy crypto directly on the platform with your bank cards.
How much you make from crypto lending depends on the demand and supply ratio, the growth rate, the lent crypto, and the lending duration. Your interest is also affected by the volatility of your crypto holdings.
APR and APY
In crypto savings, terms like "Annual Percentage Yield" (APY) and "Annual Percentage Rate" (APR) apply. The annual percentage rate is the interest rate applied to a principal over a year.
The annual percentage yield refers to the interest rate. This also includes compound interest on the lender's deposit. Both terms differ. Yet, many cryptocurrency platforms use them often. Thus, it is not easy to pinpoint what each term means. For clarity, APY refers to compound interest rates. Likewise, APR is synonymous with loan investments.
Learn more about the differences between APR and APY.
Tax on Crypto Interest: What Potential Investors Need to Know
Traders are subject to capital gain/loss taxes. These taxes apply when they buy and hold an asset for investment purposes. Investors are also subject to income taxes when they earn crypto. These taxes apply to investment opportunities like mining, staking, lending, and other means.
The percentage of this tax and what makes up a taxable event vary from location to location. Thus, it is vital to understand what taxable events apply in your locality. Also, learn how tax laws apply to your 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. Due to high volatility, these borrowers are at a higher risk for the platforms. In such situations, platforms rely on margin calls to protect their loans.
Individuals: Some individuals take out personal loans that they can repay later. This use case is quite common in the crypto lending markets.
Small Businesses: Small businesses can source financing from lenders in this space. These businesses may be unable to access funding from traditional lenders. In most cases, 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.
Crypto lending is a viable way for an individual with crypto holdings to earn interest. Crypto traders must select the right platforms to earn enough interest on deposits.
Although, there are risks to lending crypto assets. Yet, many platforms ensure that their lenders enjoy top-notch protection. These platforms ensure that borrowers provide adequate collateral for their loans.
Additionally, many of these platforms partner with insurance organizations to protect their users. Crypto traders can maximize their earnings by looking at what these platforms offer. It also requires choosing a savings account with the best returns.