The crypto-backed loans industry has been around for several years, but analysts agree that it didn’t take off until the start of the pandemic.
As financial markets entered a chaotic period, crypto hodlers needed access to cash. However, anticipating high gains, many were reluctant to sell their Bitcoin and Ether. Therefore, many entered the crypto lending sphere for the first time.
What are crypto-backed loans?
The basic principle behind crypto-backed fiat loans is to use your cryptocurrency as collateral to borrow cash. This way, you can access cash without having to sell your cryptocurrency holdings.
Why would someone want to take a crypto-backed loan rather than sell their cryptocurrency in exchange for cash? There are several possible reasons.
For one thing, crypto holders that are bullish on the long-term valuations of their assets may wish to hold onto their coins to reap the possible benefits of long-term hodling.
How do crypto-backed loans work?
Imagine that you hold three BTC worth $40,000 each. However, you need $100,000 to pay off a debt in cash. You could sell $100,000 worth of Bitcoin, but you believe that BTC will be worth $100,000 each within a year. In this situation, a Bitcoin-backed loan would be a convenient way for you to get the cash you need without losing your investment.
Another reason crypto-backed fiat loans may be of interest is that selling cryptocurrency for cash generates a taxable event in most countries.
For example, in the United States, if you sold your BTC after holding it for less than a year, you are subject to short-term capital gains rates. Depending on your adjusted gross income, this tax can cost you between 0-37% of your gains. However, using crypto-backed loans, you can make your crypto assets liquid without triggering taxation.
Who needs crypto-backed loans?
In the earlier days of the cryptocurrency industry, crypto-backed fiat loans were used almost exclusively by institutional investors and high-volume retail investors who were interested in taking out crypto-backed loans to make further investments.
For example, an institution could take out a Bitcoin-backed loan for cash that they could use to buy even more Bitcoin. This was, and is, a risky strategy that professional investors should only take on.
Nowadays, low-volume retail investors have much broader access to crypto-backed loans of all sizes. Besides buying more crypto, there are many other reasons that retail investors may be interested in taking out crypto-backed loans:
1. Funding A Business
When it comes to starting or scaling a business, there are some things that crypto can’t buy. Therefore, taking out a loan on your crypto may be the best way to get cash for your company without losing your holdings.
2. Diversifying Investments
You’ve had great success with your Bitcoin, but you’re interested in higher-risk assets or lower-risk assets. If you believe that you may benefit from diversifying your investment portfolio and don’t want to part with your crypto. Taking out a crypto-backed loan could be the perfect solution for you.
3. Paying Off High-Cost Debt
If you need to refinance debt from old credit cards or overdue student loans. Taking out a crypto-backed loan may be a good option for you. However, ensure that the interest rate on your debts is higher than the interest rate of a crypto-backed loan before deciding whether to refinance.
4. Everyday Purchases (Consumer Credit)
There’s a running joke on Twitter that crypto millionaires often have $0 in their bank accounts. Many crypto holders are hesitant to sell their coins to purchase things they might need for everyday life. Taking out a crypto-backed loan can provide crypto investors with the cash they need without having to sacrifice their holdings.
5. Paying Off Housing Debt
While there are some exceptions, one cannot pay off the vast majority of housing loans in cryptocurrency. Similarly, the vast majority of home and apartment sellers will not accept cryptocurrency as payment.
Taking out a loan against your crypto
Once you’ve decided that you would like to apply for a crypto-backed loan, you need to choose a reputable provider. When choosing a lender, ensure that they offer the products you require, reasonable interest rates, have a history of good business practices.
Most centralized crypto lending platforms will require their users to undergo thorough KYC and AML checks before taking out a loan. However, decentralized lending platforms may offer users the opportunity to get loans without undergoing identity checks.
Typically, any crypto loan provider will require lenders to “over-collateralize” their loans. They will have to lock up more crypto than the overall value of the loans they receive.
Because collateralized loans are typically much more secure for the lender, borrowers typically receive much lower cheap interest rates. Additionally, because loans must be overcollateralized, crypto loan borrowers are not subject to credit score assessments.
Once you’ve finalized the terms of the loan and deposited your cryptocurrency, you should receive your cash in less time than it would take in the traditional financial world. Crypto loans may take minutes or hours, while traditional loans could take several business days to payout.