How do Crypto Loans Work?
Decentralization is a core component in the world of cryptocurrencies. Decentralized finance, or DeFi, refers to the increasing demand for financial services based on blockchain technology. Crypto loans are one of these services.
But what is a crypto loan? In a cryptocurrency loan transaction, the borrower and the lender are two separate actors. In addition, borrowers pledge cryptocurrencies as collateral. As a result, obtaining loans with cryptocurrencies can often be less difficult in comparison to seeking approval through traditional banks.
What is a Crypto Loan?
A cryptocurrency loan is a form of secured loan. A lender provides cash to a borrower in exchange for collateral, which the borrower then repays in installments. The borrower receives their cryptocurrency back after the loan term, provided they make their payments on time and repay the loan in full.
The loan amount for a cryptocurrency is usually expressed as the loan-to-value (LTV) ratio of the cryptocurrency that the borrower uses as collateral. Binance, for example, is a lender that allows borrowers to take up to 50% of the value of their cryptocurrency;
A loan term can range from seven days to a year or longer. Interest rates start from 0% to 13%, which compares favorably with personal loans and credit cards.
For owners who are confident in the long-term growth of their crypto assets but need cash for immediate expenses, crypto loans are attractive. However, there are risks associated with crypto loans, including the need to put up more collateral if the value of your cryptocurrency drops and high fines for late payments.
Types of Crypto Loans
CeFi and DeFi are the two categories of crypto loans:
CeFi loans are custody-based cryptocurrency loans where a lender retains control of your cryptocurrency during the repayment period. The majority of cryptocurrency loans fall under CeFi.
With DeFi loans, smart contracts are used to ensure you meet the loan terms. You still have control over your crypto assets, but if you default or fall behind on payments, a lender can take automatic action against your account. Interest rates on DeFi crypto loans can be higher than CeFi's.
What Can I do with a Crypto Loan?
Like a personal loan, a cryptocurrency loan can be used at the lender's discretion and often without restrictions. Borrowers can use the money to pay significant installments, such as a down payment on a home, car, school, debt consolidation, and more.
Risks of Crypto Lending
Because loans and deposited funds depend on the constantly fluctuating cryptocurrency market, lending in cryptocurrency is risky for both borrowers and lenders. For example, many crypto enthusiasts were disappointed by the recent Celsius incident, which resulted in billions of dollars in deposits freezing overnight.
With that in mind, here are some of the risks associated with lending cryptocurrencies:
Decreases in the value of deposited collateral can lead to margin calls when customers pledge collateral and lend against it. This occurs when the LTV of a cryptocurrency loan falls below the agreed rate. In this case, borrowers have two options: add more collateral to bring the LTV back down or risk liquidation.
Crypto assets often become inaccessible and illiquid when deposited through crypto lending services. While some cryptocurrency loan services allow lenders to access deposited funds relatively quickly, others have a waiting period.
Crypto lending platforms are unregulated and do not offer the same level of protection as banks.
For example, users' funds are protected up to a certain amount if a bank fails, as US bank deposits carry insurance from the Federal Deposit Insurance Corporation (FDIC). However, there is no user protection for cryptocurrency lending platforms with solvency issues, and lenders can lose money.
Although some cryptocurrency loans have modest interest rates, most of them have APRs above 5%, and some of them have APRs as high as 13%.
How to Get a Crypto Loan
Users must register with a centralized lending platform or connect a digital wallet to a decentralized lending platform to apply for a cryptocurrency loan. Users then select the type of loan and the loan amount before determining the collateral to deposit. The available amount changes depending on the collateral and deposit.
The borrowed money is quickly transferred to the user's account or digital wallet after the user deposits the collateral into the platform's digital wallet.
Most loans are approved instantly, and loan terms are set using smart contracts.
How to Lend Crypto
Lending your cryptocurrency has a clear advantage: you receive interest on a resource that would otherwise be idle. However, as mentioned earlier, the interest rates you can receive from lending vary considerably, ranging from 1-20% for most cryptocurrencies. These interest rates stand out positively from the average interest rate on savings accounts in the US, which is around 0.1% APY.
Users must sign up with a lending platform, select a supported cryptocurrency to deposit, and then pay money to the platform to become a crypto lender. Interest can be paid in kind or with the native platform token on a centralized crypto lending platform. Interest is paid in kind on a decentralized exchange, but there may also be bonus payments.
Is Crypto Lending Worth It?
Because smart contracts are used to lend funds, crypto loans are generally safe. These contracts are secure, and most are open source. In addition, strict collateral rules protect your funds every time you lend cryptocurrency.
However, cryptocurrency lending is largely unregulated. Therefore, you are on your own if a virus or malicious hacking organization shuts down the platform where you lend crypto. There is no regulator or organization that can or will help you get your funds back.
In addition, some companies may even lock your funds on their platforms during times of difficult market conditions to prevent the site from going offline, as was the case with Celsius.
Crypto lending is a worthwhile alternative for HODLers to leave their crypto assets in their digital wallets.
It is important to be fully informed before participating in crypto lending, whether as a borrower or an investor. Crypto lending can be beneficial for both investors and borrowers if it is done on a reliable platform.