The term crypto-backed loan is giving some cryptocurrency investors sleepless nights.
These are digital assets diehards who want to amass their crypto holdings and see them surge in value.
On the flipside are believers in crypto-backed loans who question the wisdom of amassing wealth on the blockchain and failing to take advantage of existing money-making opportunities.
The truth is found in a new crop of crypto-millionaires who have taken advantage of the existence of borrowing against crypto without ever selling a single digital asset.
Several DeFi (Decentralized Finance) platforms give loans for HODLers willing to set their cryptocurrency as collateral and some interest. Cryptocurrency-backed loans are similar in structure to your specific security-backed loan, allowing you to access your crypto wealth.
How Does Borrowing Against Crypto Work?
Crypto-backed loans or borrowing against crypto is a hot topic on public social media platforms like YouTube and Reddit.
But before we can conclude whether a crypto loan is good for you, we first want you to understand precisely what it is. There are two types of crypto-backed loans, namely:
Custodial CeFi (Centralized Finance) Loans
For these loans, there’s a central authority that keeps the crypto collateral and its private keys.
Borrowers can’t access their collateralized coins until they finish paying off their loan amounts. While most crypto lenders belong to this category, matters are changing pretty fast.
Non-Custodial DeFi (Decentralized Finance Loans)
Unlike the former, the platforms offering this type of loan rely on Ethereum-based or other related smart contracts.
Smart contracts are automated agreements that self-execute once the predetermined conditions have been met. The borrower remains in charge of their collateral even though they can’t use it for anything else until the loan is paid off.
If you want to take a loan in traditional finance, you can use an asset such as a car or house as collateral for the loan. Similarly, Decentralized Finance allows using crypto assets as collateral for low-interest loans from platforms.
The first step in taking out a crypto-backed loan is signing up on the DeFi platform of your choice and choosing your desired loan amount. The platform will calculate the amount of cryptocurrency you need as collateral, which you’ll be required to deposit in a smart contract.
The platform will match you with the right lender, and once the loan is approved, you’ll receive your cash in the chosen denomination.
Once you offer you’ve received the fiat loan, you can put the money to use and repay off the loan with some interest according to the designated loan terms.
Unlike the traditional lending systems, DeFi platforms don’t penalize you for paying off the loan ahead of time. However, the lender can cash out or liquidate your collateral if you fail to repay the loan.
The smart contract will return your collateral as soon as you finish paying off your crypto-backed loan.
Compared to traditional lenders, DeFi platforms offer relatively low annual percentage rates and high minimum loan amounts. Crypto-backed loans make sense if you have a considerable amount of cryptocurrency that you want to liquidate without ever selling them.
The Benefits of Borrowing Against Crypto
Borrowing against crypto is good for several reasons. While it surpasses the traditional borrowing options in different aspects, we can only mention a few of the benefits of crypto-backed loans:
Credit Checks
You don’t have to undergo the traditional credit check before you can qualify for crypto loans.
DeFi platforms have customized ways to check for your suitability, meaning that you could still be eligible for a loan even when your credit history isn’t the best.
Your credit history notwithstanding, you will almost always qualify for a lower interest with cryptocurrency than the conventional personal loan.
Your Assets are Secure
Borrowing against crypto enables you to liquidate your assets without locking yourself out of the crypto market.
As long as you keep your end of the bargain, your digital assets remain intact during the entire loan period. Since you don’t have to sell your collateral, there are all chances that the value of your collateralized cryptocurrency could have increased by the time you‘ll be receiving it back.
Instant Funding
In most cases, cryptocurrency loans are distributed almost immediately – nothing works better when you’re borrowing due to an emergency.
This is unlike traditional lenders, who sometimes need several days to get the money you’re borrowing.
Things to Consider When Taking Crypto-Backed Loans
We’ve already seen there are several clear benefits of borrowing against crypto.
Nonetheless, due to the nature of crypto loans, there are essential things you need to keep in mind, including:
Margin Calls
Margin calls happen in the unfortunate event that the value of your collateral goes well below a given threshold.
In such cases, the lender could ask that you increase your collateral to maintain your loan. The lender could sell a portion of your collateral to reduce your loan-to-value ratio in the worst-case scenario.
You Won’t Access Your Assets
You can use your digital assets to trade or transact as long as you still have an outstanding loan amount.
Repayment Terms
Crypto-backed loans function like traditional loans, and how much they cost depends on the DeFi platform you select. Be careful to choose a repayment schedule that you’re comfortable with and which you can afford.
Eligible Digital Assets
The applicable collaterals depend upon particular crypto lending platforms. Depending on what you choose, you could be required to exchange your cryptocurrency before becoming eligible.
Secure DeFi Platforms
Be careful to use secure digital lending platforms. Take the time to read the written terms and conditions to ensure they are not written to maximize the lender’s profit margins at your expense as a borrower. That’s the only way you can avoid catastrophe later on.
The Bottom Line
Borrowing against crypto may still be a new practice, but as cryptocurrencies go into the mainstream, you can be sure that it will get better still.
Crypto-backed loans are an alternative if you have crypto holdings that you don’t want to sell yet.
No matter what you take crypto-backed loans for, make sure you repay your loan on time. Borrowing against crypto is an excellent idea and diligent repayments will help to boost your record.
What’s more, you can enhance the security of your digital assets by choosing trusted and secure crypto wallets that will keep them far from any online risks.