What exactly does it entail to borrow against your crypto?
Well, think of it like a typical loan process. Suppose you find yourself in need of funds for something desirable, be it a new Range Rover or an ambitiously priced Liberal Arts degree. In such cases, where cash isn’t readily available, you apply for a crypto loan. Upon approval, the loan provider, often a bank or another financial institution, disburses a sum of money along with a repayment schedule. Monthly payments typically cover the loan principal and interest, or solely interest in the case of an interest-only loan.
Now, when it comes to borrowing against your crypto, the concept involves receiving a lump sum of money by offering your cryptocurrency assets as collateral. Unlike traditional loans where physical assets like cars or houses serve as collateral, in crypto loans, the borrower pledges their cryptocurrency holdings.
Importantly, even though these assets act as collateral, the borrower retains ownership. Consequently, if the market value of the assets appreciates, the borrower stands to benefit from the positive change.
For those seeking financial assistance, there are individuals with substantial resources willing to lend money for a certain interest. These loans are facilitated through borrowing platforms, a topic we’ll delve into later.
Crypto Borrowing Insights for 2023: Industry Overview
In 2023, the landscape of crypto borrowing is shaped by a more prudent approach, learning from the mishaps that transpired in 2022. The previous year witnessed the bankruptcy filings of two prominent crypto platforms. Celsius and BlockFi, in the aftermath of the Terra Luna collapse. This occurrence underscored the interconnected nature of the industry; a downfall of one company could trigger ripple effects or even tidal waves for others (hint, FTX).
Moving forward, anticipate an uptick in collateral requirements for borrowers as loan providers reevaluate their risk management strategies. The driving force behind this adjustment is the anticipated growth in 2023 and beyond. Primarily driven by decentralized protocols, where computer algorithms replace human CEOs. These decentralized platforms typically mandate over-collateralization, meaning that the value of your collateral must exceed the amount you’re borrowing.
In the realm of decentralized finance (DeFi), borrowing against your crypto (and NFTs) remains possible. However, compared to the crypto loans of the past, you may need to contribute more collateral or opt for a reduced loan size to align with the evolving dynamics of the industry.
Advantages and Disadvantages of Borrowing Against Your Crypto
PROS
- Obtain cash without triggering taxes, unlike selling your crypto assets
- Enjoy low-interest rates for specific loan types, particularly when compared to traditional banking options
- Experience nearly instantaneous access to borrowed funds, as opposed to the extended timelines of traditional loans
- Crypto loan providers typically do not scrutinize personal credit history
CONS
- Exposure to the risk of margin calls, requiring additional collateral, or liquidation, where the provider sells your collateral to settle the loan
- Potential insolvency of the loan provider, leading to inaccessibility or loss of your crypto holdings
- Some providers may lend your collateral to others or employ it in trades, posing risks to your collateral in both scenarios
Who Should Consider Borrowing Against Their Crypto?
Borrowing against your crypto isn’t a universal solution, but for certain individuals, it could be a suitable option.
- Individuals seeking to unlock the value of their crypto assets without resorting to selling. If you own $20,000 worth of Bitcoin and require a $20,000 sum, selling is an option. However, selling triggers capital gains taxes on profitable Bitcoin investments, and there’s the risk of missing out on potential future gains if Bitcoin’s value surges post-sale. Opting for a crypto loan provides access to cash without parting with your crypto holdings.
- Those who prioritize financial privacy. With crypto loans, you can often bypass credit checks and avoid intrusive inquiries from bankers about how you intend to utilize the funds. Your financial decisions remain private.
- Individuals abundant in crypto assets but lacking liquidity in cash. If you find yourself consistently investing every available nickel into crypto, leaving you cash-strapped, a crypto loan offers a way to tap into the value of your substantial crypto portfolio without the need to sell.
How To Borrow Crypto In 6 Steps
Step 1: Select Your Preferred Borrowing Platform.
A borrowing platform acts as an intermediary, connecting you (the borrower) with the loan provider. Think of it like Uber, linking individuals who need a ride with the drivers available. If you’re unsure how to pick a borrowing platform, no need to fret—we’ll shortly discuss popular options and guide you on making the right choice.
Step 2: Choose a Crypto Asset for Collateral.
Now that you’ve chosen a borrowing platform, it’s time to contribute some crypto to secure your loan. As mentioned earlier, crypto loans necessitate collateral. Which crypto assets can you utilize?
- Bitcoin (BTC): A widely chosen option; certain platforms allow you to offer BTC as collateral, receiving stablecoins (coins pegged to the value of fiat, such as USD) like USDC or DAI in return.
- Ethereum (ETH): Many borrowers prefer using ETH as collateral, given its broad support across nearly every borrowing platform and its relatively stable value compared to many other token types.
Loan providers steer clear of uncertain collateral, which includes most contemporary cryptocurrencies. This precaution is reasonable, considering that the collateral is the sole value supporting the loan. The more established cryptocurrencies, comprising the majority of the market, are typically accepted as collateral by a variety of borrowing platforms.
Step 3: Decide Between an Interest-Only or Interest & Principal Loan.
When opting to borrow against crypto, you often face the choice between an interest-only loan or a traditional loan where you gradually repay both interest and principal. Each option comes with its own set of advantages and drawbacks.
Interest-Only Loan:
You’re obligated to pay interest on the loan for a specified period without reducing the principal throughout the loan’s duration. At the term’s end, you must settle any remaining interest along with the principal, either in a lump sum or through monthly payments.
- Pros: Initially keeps payments low.
- Cons: May result in a substantial lump sum or high monthly payments in the long run.
Interest and Principal Loan:
This loan necessitates regular payments (typically monthly) covering both interest and principal. The repayment schedule usually commences shortly after loan issuance and persists for a defined term until both the loan and interest are fully repaid.
- Pros: Maintains consistent payments throughout the loan’s lifespan.
- Cons: Typically more expensive than interest-only loans due to higher default risk. Interest-only loans tend to be riskier because of the loan-to-value (LTV) ratio, comparing the loan balance to the value of the crypto provided as collateral. In interest-only loans, the loan balance remains untouched. And market fluctuations affecting collateral value could prompt the platform to sell your crypto to settle the loan.
Learn more about loan-to-value (LTV) and its impact on loan rates in the dropdown below.
Loan-To-Value (LTV) Definition & Example
Step 4: Determine the Loan Amount.
As discussed earlier, loan-to-value (LTV) plays a crucial role in determining the borrowing amount. Most crypto loan platforms cap LTV at 80% or less. For instance, if you aim to borrow $4,000, you would typically need to provide at least $5,000 as collateral. However, it’s essential to consider that higher LTVs come with increased risk of liquidation and higher interest rates. To minimize interest costs and reduce risk, aim for a low LTV, ideally 35% or less.
Step 5: Link Your Wallet to the Exchange or Borrowing Platform.
Having navigated the initial steps, it’s time to grant the loan provider access to your crypto collateral. This involves connecting your wallet, where your crypto is stored, to the borrowing platform chosen in Step 1. The platform will provide instructions on how to complete this step.
Step 6: Transfer Your Crypto Collateral to Finalize the Loan.
The ultimate step is depositing your crypto collateral with the crypto loan platform. Some platforms offer an alternative where you can establish a private wallet key with the loan provider. This key enables the provider to access your crypto collateral if necessary for selling to cover the loan. Depending on the platform, your borrowed funds may be instantly available, or there might be a wait of a day or two.
Which Cryptocurrencies Are Eligible for Borrowing?
Numerous crypto loans involve borrowing stablecoins such as Tether (USDT) or Circle (USDC), which are pegged to the value of a fiat currency like USD. The stability of these coins ensures that their value remains constant during fund transfers, minimizing the risk of financial loss between transactions.
However, the range of cryptocurrencies available for borrowing extends beyond stablecoins and depends on the offerings of the selected borrowing platform. For instance, decentralized platforms like Aave provide a diverse array of options.
If, for instance, you wish to borrow Wrapped Bitcoin using Ethereum as collateral, you can explore this possibility as long as the chosen platform supports Wrapped Bitcoin for borrowing and accepts Ethereum as collateral. Wrapped tokens, in this context, mirror the price of the underlying “real” coin or token but are compatible with specific blockchain networks, such as Ethereum.
Here are the current top 5 borrowed assets on Aave:
- Ethereum (ETH)
- USD Coin (USDC)
- Dai (DAI)
- Wrapped Staked ETH (wstETH)
- Wrapped Bitcoin (WBTC)
Conclusion: Navigating Crypto Loans in 2024
Crypto loans, akin to traditional borrowing, involve leveraging digital assets as collateral for a lump sum. Insights from 2023 highlight a cautious industry post-2022 setbacks, emphasizing rising collateral requirements.
Pros include tax-efficient cash access and low interest, while cons involve risks like margin calls and provider insolvency. Ideal for those seeking liquidity without selling crypto, prioritizing financial privacy, or holding substantial crypto assets.
A 6-step guide aids borrowing, emphasizing platform selection, collateral choice, and loan type decisions. Eligible cryptocurrencies vary, with stablecoins like Tether popular but decentralized platforms offering diverse options.
In this dynamic landscape, careful planning is crucial to navigate risks and leverage the benefits of crypto borrowing.
