Crypto Loans: Your Complete Guide
Crypto loans are disrupting traditional loans and rewriting the rules. Before you decide whether crypto-backed loans are for you, learn everything you need to know here.
Cryptocurrencies are digital assets that operate on open-source networks known as blockchains. Since the birth of Bitcoin, there have been thousands of other cryptocurrencies, also known as "altcoins."
Each crypto project claims to provide a particular solution using blockchain technology. For example, Bitcoin provides a decentralized payment system on an unalterable ledger.
The blockchain solutions each crypto project provides are what give them value. So, people invest in crypto projects by buying coins and tokens, just like they buy stocks in real companies.
After purchasing crypto assets, investors might need funds for personal finances or other reasons. It might be hard to sell off your digital assets because you are illiquid, especially if the investment has yet to yield gains. Consequently, you might need to take out a crypto loan.
In traditional finance, stocks or treasury notes serve as collateral for security-backed loans. A lender can seize your securities if you fail to meet the loan agreement. Also, auto loan lenders have the right to repossess a car if a borrower fails to meet the loan terms.
In like manner, cryptocurrencies are the backbone of crypto loans. Borrowers use crypto assets like stablecoins as collateral and can even pay back loans with crypto assets.
There is a great deal of risk associated with digital assets. So, you need to think about the pros and cons of getting personal loans with crypto. This article will explain what you need to know before borrowing a crypto-backed loan.
Key Takeaways
Borrowing crypto loans allows you to invest and also easily access money to spend.
Borrowers enjoy lower interest rates.
Crypto lenders offer higher APYs than banks can offer.
The cryptocurrency market volatility is a significant risk.
How do Crypto Loans Work
A crypto loan is like a security-backed loan in which you use investments to borrow money. However, just as cryptocurrencies work differently from fiat money, crypto loans are different from bank loans. Borrowing cryptocurrency does not require a lengthy credit check or form filling process.
Instead, a crypto loan platform will only require one crucial thing: your digital assets. Having a tangible cryptocurrency investment as collateral is like having a high credit score. Not only does it make you eligible for a loan, but it also lowers the amount of money you owe compared to how much your crypto is worth. As a result, you might be paying a much lower interest rate.
Crypto lenders have a specific minimum loan amount they issue to borrowers. On Nexo, borrowers can take a minimum of $50 worth of stablecoin loans and a minimum of $500 in fiat loans.
In the same way, loan platforms have a maximum loan amount and a maximum loan-to-value (LTV) ratio they can give out. The most popular maximum LTV is 50% of your crypto collateral. However, YouHodler and Nexo seem to be generous with their offers.
The two platforms allow users to borrow up to 90% LTV of their collateral value. While the deal might be enticing, crypto loan platforms are well aware of the risks in their business. Consequently, high loan offers might attract high-interest rates.
If you fail to repay the loan on time, the loan company has significant leverage. Due to the volatility of cryptocurrencies, people who want to get a crypto loan often have to put up collateral that is worth a lot more than the loan amount. So, loan platforms can be sure that even if the crypto market crashes, a deal will still be in their favor.
Also, if the loan-to-value ratio is high, you might not be able to choose a longer time to pay back the loan. By shortening the term, loan platforms might be less affected by market volatility and the risks it brings.
Make sure you get good investment advice when deciding what loan-to-value ratio you want or whether or not to borrow money with cryptocurrency.
Are Crypto Loans Safe?
Borrowing cryptocurrencies is a financial decision that requires careful thought and planning. There are benefits to this class of assets. Regardless, cryptocurrencies carry significant risks that their users cannot overlook.
A crypto loan platform tends to provide two primary forms of service. They give out crypto loans to borrowers and provide interest accounts to lenders. Occasionally, some allow users to exchange a digital currency for another on their website. All those services require users to store their assets with the lender. Accordingly, any user might worry about their money.
How loan platforms store cryptocurrencies
Collateral provided by borrowers and assets deposited by those with saving accounts is stored with the lender. Usually, client assets can add up to millions or billions of dollars. As a result, crypto lenders partner with third-party custodians to keep these assets safe in cold storage.
An example is Nexo, a UK-based crypto lender that stores its user's crypto assets with BitGo, Ledger Vault, and Bakkt. Similarly, YouHodler uses Ledger Vault's self-custody management solution to control users' assets.
Insurance coverage
The Federal Deposit Insurance Corporation (FDIC) is a U.S. agency that protects bank depositors against losing their money if an insured bank fails. Likewise, SIPC protects investors from the loss of cash or securities if a brokerage firm liquidates. Unfortunately, there are no FDIC or SIPC protections when a crypto service provider goes bankrupt.
As a result, loan platforms employ the insurance services of third-party custodians to mitigate risks. An example is BitGo, a pioneering custodian firm that provides insurance and custodial services for crypto assets. According to Nexo, the platform insures up to $375 million worth of cryptocurrencies. YouHodler also claims insurance coverage with Ledger Vault's $150 million pooled insurance fund.
While such insurance policies promote healthy loan services, they do not cover all forms of risk. Most policies only cover the risk of theft or phishing attacks on the platform's end. There might be no coverage in bankruptcy cases, and customers might be treated as creditors in such an event.
Moreover, if hackers make it to your loan or savings account, there might be no insurance coverage. Therefore, ensure you follow all instructions to keep your account safe when using a crypto loan platform.
How lenders secure your account
Account security is vital when using a crypto loan website or mobile app. Although most platforms aim to embed their website with sustainable IT security, users need to ensure the safety of their data.
Usually, crypto lenders request that users complete a "Know Your Customer" (KYC) form during the application process. The common practice involves uploading a picture of a passport or a valid government-issued ID. While KYC confirmation might be a government policy for online lenders, it also ensures that loan platforms know the people using their services.
Crypto lenders also provide other precautions, including:
2-factor authentication
Mobile app pin
Transaction pin or password
Personally, ensure that only you can access your account and use a unique password that only you can remember. You can also read YouHodler's personal security and scam protection guide to learn more.
Crypto Loan Tax
In traditional finance, taking a loan is not a taxable event. Similarly, borrowing a crypto loan does not require the payment of tax. Interest payments can be tax-deductible, depending on the purpose of the loan. Interest payments on personal loans are not taxable events. On the other hand, interest payments on a crypto loan taken to finance a business are subject to tax.
Let's consider some scenarios that explain this.
Tom takes a crypto-backed loan to pay his daughter's school fees and settle some bills. Tom is not obligated to pay taxes while withdrawing the funds, repaying the money, or paying interest.
In contrast, Harold is short on working capital in his grocery business, so he takes a crypto loan. While Harold can cash out the loan without creating a tax event, the fund is an investment loan. Consequently, the interest payment on Harold's loan is subject to tax. Moreover, any profits from investment loans attract personal income tax.
Note that another taxable event occurs if either Harold or Tom cannot repay their loans. Going back to Tom's example, he takes a $15,000 loan and uses 0.5 BTC as collateral when Bitcoin was worth $60,000. Unfortunately, the value of Bitcoin drops to $40,000, putting Tom's loan at a 75% loan-to-value ratio.
Tom receives a margin call, but he fails to add to his collateral. Finally, Bitcoin's price drops further, and the loan platform has to liquidate Tom's collateral at $17,000. After deducting the loan amount and interest from the $17,000, Tom is subject to capital gains tax on the balance he receives.
Crypto Flash Loans
Flash loans are instantaneous, unsecured loans primarily used to profit from arbitrage trading. Unlike a traditional crypto loan, flash loans do not require collateralization. Instead, smart contracts on the blockchain ensure that the loan term is instantaneous or "flash."
You can take a flash loan on blockchain-based and pre-programmed loan platforms like AAVE. The borrower uses a smart contract to obtain a crypto asset and returns the asset within the same transaction. The most prominent use of flash loans is to take advantage of arbitrage opportunities across exchanges.
Here is a simple explanation for the scenario:
You spot a drastic price difference for an asset like Ethereum (ETH)
Take a $10,000 USDT flash loan on Aave
Use the loan to buy ETH on 1inch exchange
Sell the ETH at a higher price on Uniswap
Repay the loan and interest on AAVE
Keep the profit from the arbitrage
Meanwhile, if the transaction turns out to be unprofitable or the borrower fails to repay the money instantly, the smart contract reverses the loan to the lender. Flash loans are safe for both borrowers and lenders because no one loses money. However, there is always a risk in every crypto deal. In this case, malicious codes can cause flash loan attacks, leading to the loss of assets.
Crypto Mortgages
A crypto mortgage is a new kind of crypto service that people might find worth the risk. Unlike regular loans, mortgages can last over a decade. A crypto mortgage allows an investor to buy a home while holding on to his investment.
Usually, a crypto mortgage deal will require 100% collateralization. You might also ensure you have more digital assets to cover a margin call or an extreme market dump. Currently, most crypto mortgages accept Bitcoin, Ethereum, and a few trusted stablecoins as collateral.
As of this writing, there are only a handful of crypto mortgagees in the U.S. and Canada. An example is Milo, a U.S.-based crypto mortgage startup. The platform gives users access to 30-years crypto-backed mortgages of up to $5 million. Others include Ledn and USDC.homes.
How cryptocurrency affects your credit score
Cryptocurrency transactions have no direct impact on your financial health. However, if you fail to plan your savings properly, investing in crypto can adversely affect your credit. For instance, if you overinvest in cryptocurrencies and run out of cash, you might be unable to pay your bills. Missing out on bill payments is not good for your credit score.
In addition, obtaining a credit card debt to buy Bitcoin or any crypto might be a bad idea. If such assets fail to increase in price or even crash in value, you might fall short in debt repayment. None of those two instances directly link your credit with cryptocurrencies. However, individual crypto holders might hurt their credit score if they fail to plan their financial life.
How to get an instant Bitcoin loan
Interestingly, you can invest in Bitcoin and use it to obtain personal loans and money for other purposes. You might then wonder, "How do I use my Bitcoin to get a crypto-backed loan?"
Nexo and other platforms offer their services through a mobile application. You need to download their app from the Google Play Store or Apple Store and register an account. Afterward, you may be required to complete a KYC verification process. You can then set up your profile, including a bank account or other important information.
Before borrowing, users have to transfer their collateral from a crypto wallet to a wallet address the platform provides. Once your Bitcoin meets the minimum collateral value a platform requires, borrowing money will be easy. Ensure the loan term and interest rate align with your repayment plan during the process.
If your crypto holdings are in altcoins, you can still get a loan from most lenders. You can make further research on the best crypto loans out there. However, it is essential to use sustainable digital currency as collateral.
Can you get a Bitcoin loan with Coinbase?
Coinbase, an American cryptocurrency exchange, allows users to borrow money using Bitcoin as collateral. The platform offers a maximum of 40% loan-to-value ratio, and you can get up to $1 million in cash. Moreover, the interest rate for Coinbase loans starts from 8% APR.
Coinbase allows you to repay the interest monthly throughout the loan duration and complete the payment by the end of the term. Meanwhile, the platform claims that they do not use the Bitcoin collaterals of their clients for any investment. Therefore, you can be sure that your collateral is secure.
Selling Bitcoin is a taxable event, and some Bitcoin investors are determined holders. Therefore, Coinbase offers a viable solution for their customers needing urgent money to avoid selling their Bitcoin. Visit Coinbase to learn more or borrow money without a credit check.
Conclusion
The idea behind crypto loans is that crypto holders might be unwilling to liquidate their portfolios each time they need money. Therefore, borrowing crypto-backed loans helps to support their future belief in their crypto assets gaining value.
Multiple crypto lenders offer loans at reasonable interest rates and durations depending on your LTV ratio. In comparison to bank loans, cryptocurrency loans are easier to obtain. Coinbase and other loan platforms mentioned in this article provide crypto-backed personal loans or funds for any purpose.