What Is A Crypto Loan And How Does It Work?

Loans using cryptos as collateral have gained popularity in the crypto space in recent years. This financial instrument enables crypto holders to access liquidity without having to sell their digital assets.

Here, we will dive into details of how crypto loans work, the different existing models (CeFi and DeFi), and the requirements for these applications, ways to use the acquired capital, and the benefits and shortcomings to consider before taking on debt. Moreover, this editorial will explore practical examples of their applications, including debt consolidation, vehicle purchases, holiday expenses, and their use for trading and investment purposes.

What Is A Crypto Loan?

A crypto loan is a personal loan secured using cryptos. In other words, the borrower offers a particular amount of cryptos like Tether (USDT), Ethereum (ETH), and Bitcoin (BTC), among others, as collateral. In exchange for that collateral, the borrower gets a sum of cash, normally in the local currency, to get repaid in periodic installments over a predetermined period, which ranges from 12 to 60 months, depending on the lender.

Interestingly, the operation is similar to any other secured loan, such as a mortgage for a home or a loan used to buy a car. The main difference here is that the collateral is not a physical asset but a cryptocurrency.

By securing the loan with cryptos, the lender can seize the collateral in case the borrower fails to make the agreed-upon payments. On the other hand, in case the borrower fulfills all payments on time, they regain full control and ownership of the initially pledged cryptos.

Thus, the loans work similarly to traditional markets but with a considerably lower interest rate.

How Does A Crypto Loan Operate?

To request a crypto-backed loan, you must have a crypto to use as collateral. Once you have the cryptos, the next step is to find an entity or online platform that offers these kinds of loans. Every financial institution or platform has its conditions, so it is important to thoroughly research different options before making any decision.

When selecting a lender, set up an account on their platform and link your crypto wallet to it. This enables the lender to verify your crypto balance available to secure this loan. It is worth noting that on many of the centralized platforms, you will have to complete the identity verification (Know-Your-Customer) process, which normally needs personal and address documentation.

Once you complete the steps, you can request a particular loan amount, considering the value of the cryptos offered as collateral. Every entity sets its criteria but normally lends between 20% and 70% of the presented crypto collateral’s value.

Ultimately, sign the loan agreement, and upon approval, receive the requested funds. That normally happens quickly or within a few hours. From the moment the money is received, you can start making the agreed-upon periodic payments.

Imagine you want to borrow 100 USDT via the Binance exchange. To do that, you would have to offer 142 USDC as collateral. It means the interest linked with the loan would be 70%. It is similar to putting down 142 dollars as a deposit to borrow 100 dollars. That is a simple example using USDT, but you can do it with almost all cryptos on the platform.

Related:How to Make Money with Crypto Loans: A Simple Guide

Types Of Crypto Loans

Two types of loans can be acquired using cryptos as collateral:

1. Centralized Finance (CeFi) Loans – This is the most common kind of loan in the crypto sector. The entity offering the loan is a centralized firm or institution, such as an exchange or a regulated fintech platform like Coinbase, Binance, Kraken, Huobi, and Crypto.com, among others. Under the CeFi scheme, the borrower transfers their cryptos to a wallet designated by the lending platform. In that way, the platform safeguards and manages the cryptos during the loan term. Once the loan, and all interest, are fully paid, the cryptos are returned in full to the original owner. The benefits of these loans include quick approval, high liquidity, and low-interest rates.
2. Decentralized finance (DeFi) loans – in this case, the loan in question is not granted by a centralized entity but by a smart contract on the blockchain. Notably, these are automated peer-to-peer loans executed via code. Unlike the CeFi model, here the borrower retains custody of their cryptos in the entire process, using their non-custodial wallet.
   It means there is no need to transfer them to a third party. The smart contract manages loan release, collateral, and interest. Nonetheless, similar to the previous model, in case payments are not met, the smart contract automatically executes the liquidation of the crypto assets offered as collateral. The decentralized loan type avoids any intermediaries but comes with higher interest rates and needs an exhaustive understanding of decentralized finance (DeFi).

Using A Crypto Loan

Crypto-backed loans have become excessively versatile, enabling financing for a wide variety of personal or business needs. Here are some particular examples:

• Debt consolidation – use the acquired capital to pay off or refinance previous debts, including credit card balance, bank loans, and personal loans. This strategy helps improve cash flow by consolidating various payments into one at a significantly lower rate than the traditional banks.
• Trading and investments – crypto investors mostly reinvest the borrowed money into different cryptos or DeFi projects that promise increased growth potential, which is more than the crypto they currently own. For instance, an investor may borrow USDT to acquire ADA expecting the launch of new products on the Cardano blockchain, and repay the loan at year-end with the generated profits in case ADA’s price increases.
• Vehicle purchases – whether it is a truck, a car, a motorcycle, or even a boat, crypto loans are perfect for covering expenses that normally need lots of cash outlays.
• Travel and vacations – Most people utilize this kind of financing to fund their leisure trips, whether it is the dream Caribbean cruise or a luxury vacation somewhere in Dubai.

Related:Crypto-Backed Mortgages: What Are They And How Do They Operate?

Benefits And Shortcomings Of Crypto Loans

Acquiring money via a crypto-backed loan has multiple benefits compared to other kinds of financing. Nonetheless, it also has some risks worth talking about.

Among the main benefits of crypto loans include:

• Low-interest rates –these loans normally have considerably lower interest rates than credit cards or unsecured personal loans. In some cases, rates can start from as low as 0.95% annually.
• Quick approval – there is no need to verify credit history or offer financial documentation. The application is 100% online and is normally approved the same day, which makes it perfect for resolving emergencies.
• Flexible use of funds – these funds can be reserved for any legal purpose, from paying debts to investing in brand-new assets. There are no limitations.
• Tax management – access liquidity without selling crypto assets and possibly incurring capital gain taxes.

The shortcomings of crypto loans to consider include the following:

• Possible margin calls – extra injections of cryptos might be needed to replenish the assured value.
• Partial loss risk – in case the value of the offered crypto collateral plunges considerably, the borrower might encounter partial liquidation to cover the losses.
• Limited access to cryptos – while the loan is active, access or trading with the collateral assets might be limited.

The Takeaway

In general, looking for a loan using cryptos as collateral is an attractive option for those who are seeking liquidity but are unwilling or unable to sell their current holdings.

Nonetheless, it is important to fully understand the possible risks of taking out a crypto loan before proceeding. While the interest rates are significantly low and the process is accelerated, there is a real potential of losing all the pledged holdings via margin calls or partial liquidations of the involved assets.

Hence, before applying for a crypto loan, thoroughly research the terms and conditions of each platform. Compare all these platforms to find the one with the lowest interest rate, and ensure that you have a backup plan in case the value of the collateral cryptos dip abruptly. Remember that the crypto market is renowned for its extreme volatility.