How Crypto Lending Works
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.
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 throughout a much more extended period.
How Crypto Compounding Interest Works
The best way to understand this is to look at a simple example. If we deposit 1 BTC into a crypto lending platform with a simple interest rate of 5% at the end of the month, we'll be making 1.05 BTC at the end of a month and 1.6 BTC at the end of the year. That's not a bad rate of return. However, if we deposit the same 1 BTC in an account that generates compound interest at the rate of 5% compounded monthly over a year (12 months), our return would be 1.795 BTC at the end of the year. The more years we put into this calculation, the wider the gap between simple and compound interest.
For this comparison, if we left that 1 BTC in both accounts for five years, the simple interest account would only afford us 4 BTC total after the five years. However, the compound interest account would offer us 18.679 BTC over the same period. That's a difference of around 15 BTC!
Platforms that Pay Compound Interest on Crypto
Naturally, the interest rates on lending platforms vary, but some offer impressive rates on crypto deposits. BlockFi is renowned for its crypto compound interest rates, with depositors accessing rates of 7% APY on USDC savings.
APR vs. APY for Crypto
How can you tell whether your crypto savings will be simple or compound interest? Most platforms represent the type of account they offer through the terms Annual Percentage Rate (APR) or Annual Percentage Yield (APY). In a nutshell, APY describes a compound interest account, while APR refers to simple interest only.
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 for flash loans. 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 on 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 cannot 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 into 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 be facing a margin call, where their assets are liquidated, and the value returned to the lenders.
How to Maximize Crypto Interest
Maximizing crypto interest relies on finding the right crypto savings to earn compound interest from. How does a digital asset holder choose the right savings account? It would help if you looked at several criteria when determining how to maximize your crypto interest.
- Interest Rate: Higher interest rates usually mean better returns over time. Look for platforms that offer compound interest (APY) instead of simple interest (APR).
- Using Leverage: The term "yield farming" has been used to refer to taking out crypto loans to reinvest within a platform. While this does offer the potential for greater earnings, it also has a lot more risk associated with the practice.
Which Crypto Has the Highest APY
Currently, Midas.Investments offers the best return of 18.05% APY on USDC.
Who Pays the Highest Interest on Bitcoin?
Currently, Nexo offers some of the best ROI for savings, with their Bitcoin Savings offering up to 8% APY on BTC deposits.
Should You Lend Your Crypto?
While you should do your own research on whether you should lend your crypto, you can make significant gains if you do so. Deciding to lend your crypto means figuring out which platform you should deposit into. Crypto lending platforms come in two varieties: centralized and decentralized platforms. Centralized platforms have a central authority responsible for all the platform's actions. If things go wrong or there's some discrepancy, the lender can make a report to the centralized administration and have it fixed. Some centralized platforms even offer deposit insurance, making them less risky than other crypto lending platforms.
Decentralized lending platforms are a bit riskier to put your digital assets into. These platforms are governed by smart contracts, which automatically determine the interest and borrowing capacity (LTV ratio). Unfortunately, since smart contracts are not infallible, any problem in their coding can lead to issues later on. Decentralized finance is a lot riskier than depositing in a centralized platform.
How Much Can You Make Through Crypto Lending?
The amount you can make through crypto lending depends on the platform. These platforms determine rates of interest for deposits and how often the depositors receive interest. With enough digital currency deposited in the lending platform, a depositor can potentially secure steady passive income. Crypto lending rates at this point are attractive because of all the factors that make crypto lending so profitable. Among these factors are:
- Supply and Demand: Taking out a secured loan using crypto collateral is attractive to many individuals. Borrowers can secure personal loans or business financing without going through a credit check.
- Early Adoption: Interest rates are high in these lending platforms because they need the digital assets on hand to lend. Getting on board before the space gets inundated ensures that lenders can maximize their earnings.
- Growth Rate: Because of the rate of interest on these loans and the fact that a lending platform may compound that interest weekly or monthly, there's a real opportunity for massive growth.
How To Lend Crypto
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.
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 them 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.
Crypto Lending As Income Generation
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.