How Crypto Loans Work
We demystify the process of crypto loans and offer some insight into the best options for borrowing against your crypto assets.
Since Satoshi introduced Bitcoin in 2008, cryptocurrencies have gradually infiltrated most facets of the financial system. As they are touted to be the future of finance, there is hardly anything you can do with traditional currencies that you can't do with cryptocurrencies.
For example, you can exchange digital assets with one another as is done in forex, purchase goods and services with crypto, and use crypto cards and even crypto ATMs for cash purposes.
Then, it should not be surprising that cryptocurrencies have also disrupted the traditional loan system. In recent times, crypto loans have gathered considerable interest and are seen by many to be healthy alternatives to conventional loans. In fact, crypto lending was the biggest aspect of the DeFi world as of March 2022.
How does it work? What are the intricacies and mechanisms involved? Are there pitfalls? This article will answer those questions and more. We will cover the crypto lending world from the borrower's perspective and introduce you to some crypto loan terminology.
Let's start with a definition.
What Are Crypto Loans?
Crypto loans, or crypto-backed loans, are secured loans that use digital assets as collateral. They offer smart ways to cash in on the value of your crypto holdings without selling them.
They started gaining popularity in early 2020, when the entire financial world suffered a massive meltdown due to the COVID-19 pandemic. Many sold their crypto holdings, while those who held on to their crypto assets needed to find a way to make these assets work for them.
Crypto loans easily fill that need. They rewarded crypto enthusiasts for HODLing (holding on). They also provided a way to get quick cash to settle urgent personal expenses without letting go of prized crypto assets.
Now that we have a definition, let's discuss how some crypto loan mechanisms work.
How Crypto Loan Collateral Works
The collateral is the crypto asset you put down as security when taking a crypto loan. It's a common term in the finance world and basically assures the lender that they will get their money's worth even if you default in repaying your loan.
In most cases, crypto loans are over-collateralized. In other words, your collateral is worth more than the amount you borrow. For example, if you want a crypto loan of $10,000, you might have to put down crypto collateral worth $15,000 or more, depending on your LTV ratio (we'll explain this later).
There are also under-collateralized and even non-collateralized crypto loans. Though easier to access, these loans may present more risks for the lender than over-collateralized loans.
Still curious? Click here to dive into how crypto loan collateral works.
How Collateralized Crypto Loans Work
Bitcoin, Ethereum, Binance Coin, and USDT are just some of the cryptocurrencies you can use as collateral for crypto loans. You can also use NFTs and even meme coins as collateral. You're good to go as long as the lending platform supports your asset as collateral.
Remember, however, that the more volatile a crypto collateral is, the more susceptible it is to liquidations. Therefore, use digital assets with large market caps as much as possible. These coins suffer from fewer severe price fluctuations and have deeper liquidity.
Also, as mentioned earlier, not all crypto loans attract collateral. Therefore, you may not be required to put up collateral in some cases.
How Crypto LTV Works
The LTV ratio of your loan describes the relationship between how much you put down as collateral and how much you get as the loan amount. It is also like a gauge showing how close you are to liquidation.
The starting LTV ratio for most volatile crypto loans is between 20% and 50%, while stablecoin loans can come with an LTV as high as 90%.
So, collateral worth $10,000 will give you a $2,000 loan value with a 20% LTV ratio, while the same collateral will provide you with a $5,000 loan value with a 50% LTV ratio.
Don't let the high figures fool you, though. A high LTV ratio is usually an ominous sign that liquidation is near.
Still curious? Click here to dive into how crypto LTV works.
How Crypto Loan Liquidations Work
Liquidation is a nightmare for crypto loan borrowers. In essence, it means you've lost your collateral, and you would have been better off selling it to fulfill your needs. No one wants it to happen, but sometimes it has to happen.
So when you notice that your LTV ratio is shooting up and approaching the dangerous waters of liquidation, take appropriate measures to bring it back down.
How can you reduce, or avoid altogether, the risk of liquidation? The following measures can help:
Use stable cryptocurrencies as collateral to reduce the effect of price fluctuations.
Keep some cash on the ground to add to your collateral if need be.
Keep an eye on the markets, and set alerts so that you can act on time if the market starts declining.
Still curious? Click here to dive into how crypto loan liquidations work.
How Crypto Loans Affect Your Credit Scores
A credit check is when a company or bank checks your previous financial records to determine whether you're eligible for a loan. They then rank your creditworthiness from 300 to 850. In most cases, you need a good-to-excellent credit score (670-850) to secure a loan.
Even though you do not go through a credit check before getting a crypto loan, you still need to be careful how you take and spend crypto loans so as to protect your creditworthiness.
For example, if you take out your loan in cryptocurrencies, you are liable to pay capital gains tax. If you do not pay your taxes on time, your credit score may be negatively impacted.
Still curious? Click here to dive into how crypto loans affect your credit scores.
How Crypto Loan Tax Works
Tax rules favor the borrower more than the lender in a crypto lending arrangement. How so? If you take a crypto loan for business purposes, the loan interest you pay is tax-deductible. Also, if you take your loan proceeds in fiat or stablecoins, you can spend as much as you like without paying a dime in taxes.
In some cases, though, you may have to pay taxes. For example, if your loan is liquidated, you may pay a capital gains tax. Your earnings may be taxed if you take a self-repaying loan.
Still curious? Click here to dive into how crypto loan tax works.
How To Get An Instant Crypto Loan
You can get a secured loan instantly from a crypto lending platform. This is a crypto exchange that mediates between a lender and a borrower, ensuring that their relationship goes as planned.
On these platforms, a central authority takes the loan from lenders and gives it to borrowers. It also collects interest payments from the borrowers and gives the lenders their cuts. Examples are Nexo, BlockFi, Hodlnaut, etc.
Each crypto lending platform has its own parameters, including interest rates, minimum loan amounts, fees, etc. It's best to research these terms of service before signing up with them.
Still curious? Learn more about instant crypto loans
How To Use A Crypto Loan
Now that you have taken your crypto loan, what next? What will you use your loan for? That largely depends on you. After all, you must have had a reason for getting the loan in the first place.
But apart from using your loan to fill some urgent needs, there are other things you can do with it. For example, you can use it to buy other promising crypto assets, thus diversifying your crypto portfolio. You can even use it to invest in other assets outside the crypto world, like real estate, stocks, commodities, etc.
Remember that a loan is a debt you will eventually have to pay back. So, consider all your options well before deciding what you'll use the loan for.
Still curious? Click here to dive into more ways to utilize a crypto loan.
How Does a Crypto Loan Work?
So, how does it all go down? Let me take you through the three-step process that usually accompanies crypto borrowing.
Step One - Getting The Loan
What You Need
To get a crypto loan, you may need to sign up with a crypto lending platform, perform KYC verification if necessary, and be ready with your collateral.
You may not always need these three things. For example, some crypto lending platforms don't require KYC, while others don't require you to bring collateral. Sometimes, you may not even need a crypto lending platform (like if you engage in direct P2P borrowing).
What You Don't Need
You do not need a credit check to get a crypto loan, nor do you need to come up with a guarantor. You also do not need to be physically present with your lending provider before your loan can be disbursed. Sometimes certain types of crypto loans can be an exception like a crypto loan for mortgages which require much more capital and have additional risks.
Step Two - Maintaining The Loan
Like a garden, a crypto loan needs tending. You need to monitor your LTV ratio to ensure you are not edging towards liquidation. Particularly for flash loans. Most lending platforms provide margin calls to alert their users to make the necessary adjustments.
In some cases, you get a reverse margin call. This occurs when the price of your collateral has increased to the extent that your LTV ratio is now much lower than what you started with. You may then take back some of your collateral or get a bigger loan.
Step Three - Closing Your Crypto Loan
You can close the loan by simply repaying your debt when you're done with your crypto loan arrangement. However, it's not always as simple as it sounds. Sometimes, you have to watch out for prepayment fees. These are fees that crypto lenders charge borrowers if they repay the loan before the loan term expires.
That sounds strange, right? Well, some lenders do this because repaying a loan early robs them of weeks and months of interest that they would have otherwise gained if the loan had stretched its full term. So they charge you to cover up for such a 'loss.'
That's why you should read the fine print and know-how their crypto lending works before signing up on a crypto lending platform.
The Pros and Cons of Crypto Loans
You don't have to sell your crypto assets to cater to expenses. Therefore, you don't miss out if your held crypto increases in value.
You don't need excellent credit scores before securing a crypto loan, as there are no credit checks.
There is little or no geographic restriction for crypto loans.
Those who take crypto loans enjoy instant disbursement within minutes sometimes.
Crypto loan borrowers usually pay lower interest rates than traditional loan borrowers.
You can lose your crypto collateral if things don't go your way.
As it is a relatively new type of loan, there are regulatory and safety concerns.
A crypto-backed loan is a smart way to use your crypto assets without disposing of them. However, like many other things in the crypto world, you will do better if you're well-informed. We hope this article has done its part in showing you how crypto loans work, including pitfalls to avoid and how best to benefit from them.