Crypto for Experts DeFi

Crypto Loans Explained

Crypto Loans Explained

Crypto loans offer a great way to earn interest on your crypto holdings or offer your crypto assets as collateral to borrow immediate cash for further crypto investments.

As a beginner crypto investor, you’ve probably heard the advice to hold onto your assets until the prices rise so you can sell them for higher returns. While this works, it’s logical to consider alternative ways to earn from your holdings in the meantime. Crypto lending is one of the methods investors use to profit from their digital assets.

As much as crypto lending is becoming a lucrative investment avenue, it comes with caveats. Let’s take a closer look at the ins and outs of crypto lending and borrowing. 

What is Crypto Lending?

Crypto lending is a type of decentralized finance (DeFi) service that enables investors to offer their crypto holdings to individual borrowers and entities as loans. Lenders earn interest, while crypto lending platforms use lenders’ crypto assets to fund loans to borrowers in either crypto or fiat currency like USD and EUR. 

Cryptocurrency loans are similar to traditional bank loans but they differ in some respects. Most importantly, crypto lons use cryptocurrencies as collateral from borrowers instead of creditworthiness assessments. Several platforms that specialize in crypto lending also accept stablecoins.

So, what does crypto lending look like from an investor point of view? Let’s imagine you have 100 BTC that you want to HODL. If you simply deposited these funds in the wallet of a cryptocurrency lending platform, you’d be able to receive interest on the deposited funds. Usually, you can either receive weekly interest payments or monthly payments, depending on the lending terms. The interest rate typically varies between 3% and 7%, but some platforms have offered as high as 17%.

From a borrower’s perspective, you engage the crypto you own as collateral or as a guarantee of loan repayment. Investors can sell their borrower’s cryptocurrency if the latter proves unable to service their loans as per the initially agreed loan terms. Crypto loan platforms are usually unable to recover losses and they ask borrowers to cover between 25% and 50% of their cryptocurrency loan amount. This is useful since borrowers may simply refuse to pay back the loan.

How Crypto Loans Work

Cryptocurrency lending takes place via a third party that connects lenders with borrowers. Crypto lenders are the first party involved. These can be crypto enthusiasts looking to boost the profit from their digital assets while waiting for their value to rise on the market.

The crypto lending platform is the second party initiating the loan transaction, while borrowers come as the third party in the process, receiving the funds. While the procedure may vary depending on the platform, the process usually starts with a borrower requesting a loan on a crypto lending platform. 

The borrower provides certain crypto collateral upon application, and the lender will release the requested funds after confirmation. The collateral funds remain in custody of the loan platform until the borrower repays the entire loan. Investors will receive regular interest on their funds from the lending platform, as per the initial agreement. Borrowers will receive their share or cryptocurrency collateral back after loan repayment is complete.

You can obtain this type of loan through a cryptocurrency exchange, among other platforms. The leader in this matter is Binance, and its product Binance Loans in particular. Other popular crypto lending exchanges currently include Nexo and BlockFi

On the other hand, decentralized exchanges (DEXs) like Aave, decentralized autonomous organizations (DAO) like Maker Dao and other lending platforms in DeFi usually offer better interest to lenders and more attractive loan-to-value ratio to borrowers. This is possible thanks to the use of automated smart contracts in place of a central authority that acts as an intermediary in the loaning process as with centralized exchanges.

Crypto Loans with Collateral

In the case of traditional bank loans, the lender’s security rests on the borrower’s creditworthiness. The bank determines the loan conditions, including the repayment period, installments and the loan amount, using specialized databases. 

Crypto lending platforms don’t have the option to perform credit checks so they must require collateral in the form of crypto. By taking out a collateralized crypto loan, you retain ownership of the assets you used as collateral. However, you lose the ability to trade them during the repayment period. 

Crypto Loans without Collateral

In the crypto market, there’s not really a way to measure credit score other than by using digital assets as collateral. Every now and then, platforms that offer crypto-backed loans across different countries claim that they don’t require collateral. There’s a high chance that such offers turn out to be a scam.

Otherwise, uncollateralized crypto loans work very similar to regular bank loans. Borrowers pass a creditworthiness review and loan application process including KYC verification. They can get approved or rejected. For lenders, depositing crypto assets to fund loans without collateral involves high risk of loss. Usually, there are no legal regulations in place for crypto loans to protect investors.

Who are Crypto Loans for?

Crypto owners who expect the value of their crypto holdings to increase over time are usually those who opt for taking a crypto-backed loan. The point of taking a loan is to engage their crypto assets and use them to get extra funds for immediate buys.

Crypto Lending Risk: Are Crypto Loans a Good Idea? 

From an investor point of view, there’s always the risk that the borrower won’t repay the loan they have taken. To protect yourself against this risk, you can opt to use the services of a crypto lending platform that applies appropriate security measures. For instance, the Aqru platform only grants loans to verified users.

From a borrower’s perspective, the risk is real. If the specific combination of crypto coins and tokens on your portfolio that you provided as a collateral drastically loses in value during the loan repayment period, you may default on the loan. This way, you’ll owe much more in the end than the amount you borrowed initially. 

Due to the market’s high volatility, crypto loans tend to have a very low loan-to-value ratio.

Crypto Loans and Tax Benefits

How is borrowing or lending crypto taxed? It’s important to understand the tax implications of crypto-backed loans because this can largely influence how profitable this option is for you, either as an investor or a crypto borrower.

Similarly to mortgage loans taken out from a bank, the funds you receive when borrowing crypto are not taxable according to US crypto tax regulations, as well as in many other countries. Spending the funds received as a crypto loan is also not a taxable event regardless of the way you spend them. 

Therefore, experienced crypto traders often use crypto loans to optimize their tax liabilities. When the value of a crypto portfolio significantly increases, selling will require paying capital gains tax. Instead, opting to take out a crypto loan using these assets as a favorable collateral will avoid tax liability while bringing the same benefits as if the crypto were sold. 

However, it’s important to note that not paying back the loan could lead to a taxable event. So, the risks involved in crypto loans remain and cannot be offset against tax savings. 

Crypto Lending vs Staking

In simple terms, staking compares to traditional bank deposits. The bank offers its clients a certain interest rate in exchange for the permission to use the deposited savings. If the client withdraws the deposited funds, this will entail a loss of profit.

Similarly, staking involves investing cryptocurrency units, which the blockchain can use for transaction verification and network maintenance operations. Therefore, your staked crypto helps keep the blockchain up and running. This is only possible with proof-of-stake (PoS) consensus-based crypto coins, such as Ethereum or Cardano

Unlike banks’ relatively low interest rates, however, staking can bring investors rewards of up to 20%. The annual percentage yield (APY) is the method used to calculate the reward amount.

Crypto Loans vs Yield Farming

Both methods allow you to get passive income but they use slightly different mechanisms. Yield farming works by locking crypto coins into liquidity pools on decentralized crypto exchanges (DEXs) to provide them with the necessary liquidity. The crypto you put in the liquidity pool remains locked for a certain period of time, during which you receive interest. The newer and less liquid the cryptocurrency, the higher the interest rate.

Crypto loans work similarly. Instead of transferring your crypto assets to the liquidity pool, though, you only need to deposit them to a dedicated savings account. Your cryptocurrencies thus go to others who want to borrow them.

Takeaways

Crypto loans have become a convenient way for investors to profit from their crypto holdings with less risk involved. However, you should find a reputable crypto lending platform with better loan terms and interest rates to safely invest your funds.

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