How Collateralized Crypto Loans Work
Find out exactly how you can use your crypto as collateral for a cash loan.
In exchange for a loan amount, a borrower can get a cryptocurrency loan by putting up digital assets (crypto) as collateral. Its operation is similar to car loans, where you obtain the loan and then pay it back over a certain period.
Crypto lending can help investors receive additional interest on their holdings. Also, when an investor needs cash but can't get it because his assets are already being used, he can use these digital assets as collateral to get a loan in stable coins to meet his needs. It is a great way to unlock capital without having to possibly pay taxes.
A crypto-lending platform serves as the intermediary between lenders and borrowers. This platform, the lenders, and the borrowers come together to make crypto loans possible.
An Analogy of How the Collateralized Loans Platform Works
Dean has 3 ETH and some digital assets that he has been holding. He needs cash or a stable coin to pay for some personal expenses, but he doesn't want to sell his crypto assets because he's sure their prices will go up a lot in a few months. Dean is also concerned that if he sells his crypto assets now, he might be forced to buy them back at a higher price in the future.
The million-dollar question is: Can Dean get funds to fix his needs while keeping his crypto assets? Yes! He does this by taking a crypto loan.
Dean's situation is exactly where crypto loan solutions excel. Using any of the crypto loan platforms out there, Dean will be allowed to use his crypto as collateral assets to receive a secured loan amount. To meet his needs, Dean is getting personal loans without even having his credit checked.
Due to how volatile the cryptocurrency market is, most platforms will ask Dean to "overcollateralize," or put down more collateral than the loan is worth.
When he repays the loan amount with interest, his digital assets will be returned. If the digital assets appreciate, he gets to keep the profit. On the other hand, if the value of the asset drops below the loan amount, his collateral is at risk.
Effect of Volatility on Collateralized Loan Funds
Volatility is a double-edged sword in the financial markets, and this also holds in the world of collateralized crypto loans. While it can be your friend, it can be an enemy to the borrower whose digital asset is currently serving as collateral on a platform.
Because the crypto market is still young and very reactive, Bitcoin and other digital assets are prone to huge swings in the short term. This affects, or sometimes puts, crypto lenders and borrowers in unfavorable conditions.
Declining Market Conditions
In an event where the pledged crypto declines below the value of the loan received, his crypto would be at risk if he failed to keep up with the loan's terms. To keep his loan-to-value ratio (LTV) up, the platform might ask him to pledge more crypto.
If the market keeps declining and the borrower fails to add more collateral, he would then face a margin call—a situation where he loses all his collateral. This is done by the platform to protect the lenders' interests.
Appreciating Market Conditions
Let's say that the value of Bitcoin or another digital asset that a borrower uses as collateral goes up a lot. In that case, the borrower can get rid of the extra collateral he put up for his loan, as long as he meets some conditions set by the platform.
Loan-to-value Ratio (LTV)
The platforms examine the lending risks that they would incur before approving a crypto secured loan. This examination is called a loan-to-value assessment. It measures the relationship between the loan and the market value of the crypto asset used as collateral.
For example, a 20% LTV for Dean mentioned above will mean that for Dean to get a $10,000 loan, he must provide collateral worth $50,000.
Most platforms require overcollateralization. Typically, the amount of USD you can borrow depends on the amount of collateral you post against the loan and which LTV (loan-to-value ratio) you choose.
How Do You Get a Crypto Loan?
Unlike personal loans from traditional institutions, getting crypto loans is easy and almost seamless for the borrower. Before giving out a crypto loan, most platforms do not check the borrower's credit. You do not even need a bank account to secure financing.
You sign up for a platform, figure out how much of a loan you need at the very least, and then put up your crypto assets as collateral. After you agree to the terms and conditions, the platform gives you a safe loan in stablecoin, which you can then turn into real money if you want.
Borrowers can choose between getting a crypto loan from a centralized or decentralized platform.
What happens if you default on your crypto personal loans?
There would be penalties for defaulting on your crypto loan; the collateral will be used to liquidate such payments, as that's the way the lender is being protected.
To avoid this, when considering whether to take out a loan, you should first establish what you will be using the loan for and how long you need to put the financing to work. You might consider consulting a certified financial planner before making these decisions.
Collateralized crypto-secured loans are very powerful tools that let a borrower unlock the value of his crypto assets. They help crypto lenders passively maximize the returns on their assets as well.
Whether you choose a decentralized or centralized loan platform, a collateralized loan can serve your needs. When you next sell a crypto asset for stablecoin or cash, think carefully about whether you could instead use that asset to get a loan. A world of opportunities might be opened up to you.