Crypto Loans: Function & Risk Explained
Do you need to borrow money? Are you considering a crypto loan? Unlike traditional trading loans, crypto loans are a relatively new investment strategy that offers cryptocurrency investors an alternative for accessing cash without liquidating out of their current tokens.
We’ll explain how crypto lending works, the benefits of crypto loans, and what risks you should be aware of before your borrow. For some, crypto lending might be a great tool in their cryptocurrency investment strategy.
What is Crypto Lending and How Does It Work?
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- Need quick cash.
- Want a high-interest yield on long-hold crypto tokens.
- Don’t want to go through a credit check.
- Want a lower-rate short-term loan.
How Crypto Lending Works
- A borrower applies for a crypto loan where they are must offer specific crypto tokens as collateral for the loan. The value of the collateral will determine the amount of the loan.
- Once the borrower locks their cryptocurrency as collateral, the lending platform will fund the borrower with the total amount of the loan. The platform will payout as cash or another cryptocurrency.
- The borrower must repay the loan within the set term with interest.
- Once the loan is paid in full, the lender will unlock the collateral and return it to the borrower.
If the borrower fails to pay the loan, the platform will keep the cryptocurrency as payment.
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Benefits of Crypto Loans
There are several reasons why people like to use a crypto loan over a traditional centralized loan:
- Lower Interest Rates: Cryptocurrency lending platforms offer low-interest rates when using crypto-backed loans. These rates are usually in the single digits, which is significantly less than a credit card or unsecured personal loan.
- Set Realistic Limits on How Much You Can Borrow: Crypto loans are based on the amount of crypto assets you offer as collateral to determine how much you can borrow. The platform might let you borrow up to 50-90% of the cryptocurrency’s value.
- No Credit Check: Because you are borrowing against the value of the collateral crypto value, the lender isn’t worried about your credit score because it can assume the collateral tokens if you default on the loan.
- Fast Funding: Most crypto loans will fund in the same business day, making it easy to get cash fast through a crypto-secured loan.
- Ability to Lend Your Crypto: Many crypto lending platforms allow you to stake your tokens in their platform for others to borrow to earn a high-interest yield. This is an excellent way for your crypto tokens that you plan to hold for a long-term investment to earn money.
- Liquidate Your Crypto Without Paying Taxes: By funding the loan with your crypto, you aren’t charged the capital gains like when you pull your crypto out as cash. So paying a 4-5% low-interest rate is much better than paying 20% in capital gains from cashing out.
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Risks of Crypto Loans
There are a few risks associated with crypto loans that you need to be aware of:
- Subject to a Margin Call: Because cryptocurrency is so volatile, if the price drops significantly on the tokens you’ve used as collateral for the loan, you may have to deposit more crypto to offset the price drop. Or the platform may sell some of your crypto tokens to reduce the loan-to-value ratio. Both situations are not ideal.
- Collateral Can’t be Accessed Until the Loan is Paid: When you lock up your crypto assets, you can no longer use them for trading and payments until the loan is paid in full.
- Loans are Often Short-Term: Depending on the platform you use, you may have to repay the loan in less than a year. You’ll want to calculate whether you can afford to pay back the loan within the time specified.
- Not All Tokens are Eligible as Collateral: Each platform has a list of specific tokens they accept as collateral for the loan. So you may have to exchange your tokens for another currency to get a loan.
- Loans Aren’t Federally Insured: If the lending platform gets hacked from a security breach, you could lose all your funds, and the platform isn’t obligated to guarantee you’ll get your tokens back.
How Safe are Crypto Loans?
The cryptocurrency market by nature is extremely volatile, making it an ideal environment for investors who don’t mind the risk. But recent lawsuits like BlockFi have triggered the government to crack down on some of these DeFi lending strategies. So we will see how this reshapes the crypto lending future. Many established platforms are proactively proposing how to regulate crypto lending to ensure a win-win solution.
If you do decide to try crypto lending, here are some strategies to minimize the risks:
- Use well-established lending platforms.
- Monitor crypto regulations in your country.
- Borrow, lend and get rewards in stablecoins or fiat vs. an altcoin.
- Don’t use DeFi platforms to protect against a security breach.
Crypto Lending Can Be a Powerful Investment Strategy
Depending on your crypto risk tolerance and stomach for the cryptocurrency market’s volatility, you may want to utilize crypto lending as part of your crypto investment strategy. Crypto loans offer some high yields and low-interest rates for those holding large amounts of long-term tokens. Before getting into crypto lending, you should do your research to understand the risks and rewards fully.
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