Digital currencies have grown in popularity over the years. This growth triggered the emergence of new useful financial services. Crypto lending is one such service. Crypto loans allow individuals and organisations to borrow money using their cryptocurrency as collateral. Let’s learn more about this topic.
Understanding crypto loans
In the digital currency industry, crypto loans are relatively new. The concept has grown in popularity only in recent years. Essentially, the process means utilising crypto as collateral to secure a loan. Thus, it’s similar to a typical loan. However, there are several distinguishing aspects that set it apart from traditional lending.
Borrowers can use their cryptocurrency as collateral for a loan denominated in another cryptocurrency or a fiat currency. Borrowers can gain access to liquidity without having to sell their digital holdings, which is useful in a market where the value of cryptocurrencies is highly volatile, and it can increase in the future, bringing profit.
Suppose a borrower owns 1 BTC and requires funds to cover an unexpected expense. Rather than selling Bitcoin, the borrower can use it as security for a loan in fiat currency or cryptocurrency. This allows them to access the funds they require without selling even the smallest portion of that 1 BTC.
Lenders can earn interest on their cryptocurrency holdings by lending them to borrowers. Crypto loan interest rates vary based on the platform, the type of cryptocurrency used as collateral, and other factors. Crypto loan interest rates are generally higher than traditional loan interest rates.
How it works
As mentioned, the best crypto loan works by providing resources to a borrower in return for their crypto holdings that are used as collateral. Typically, the crypto lending process consists of numerous parts.
First, the borrower selects a crypto lending platform or service and registers for an account. Then they send crypto holdings into a platform-provided wallet, where coins are stored as collateral for the loan.
Next, the borrower specifies the loan amount and the loan parameters. These parameters include the interest rate and payback period. The lender evaluates the loan request and the borrower’s collateral, and if the loan is approved, the funds are deposited into the borrower’s account.
The platform deducts the principal and interest from the borrower’s account and returns the collateral to the borrower’s wallet once the loan is repaid. If the borrower fails to repay the loan, the platform may sell the collateral to cover the outstanding loan sum.
Lenders deposit their digital holdings into a wallet given by the platform and choose which borrowers to lend to based on the interest rate, collateral, and other factors. The website connects lenders and borrowers and launches loan crypto.
By lending their crypto assets to borrowers, lenders can earn interest on their holdings. As mentioned, crypto loan interest rates are generally higher than traditional loan interest rates, reflecting the additional risk associated with lending and borrowing cryptocurrencies.
Pros and cons of taking out a crypto loan
Typically, borrowers and lenders can gain from cryptocurrency lending. Borrowers benefit from having access to liquidity without selling crypto, which is especially appealing if they trust the value of their cryptocurrency will climb further. However, even the best crypto loan platforms have a few disadvantages for borrowers. Let’s check out the pros and cons so that you can evaluate risks before taking on a crypto loan.
Let’s first check out the numerous benefits of taking a crypto loan:
- No credit checks. Traditional lenders usually need a credit check before accepting a loan. Such a check can be difficult for individuals with bad credit or no credit history. In this case, the value of the borrower’s collateral determines the borrower’s creditworthiness rather than their credit history.
- New investment opportunities. Taking up a crypto loan can provide access to new investment opportunities that standard finance solutions rarely provide.
- Liquidity. One of the most significant benefits of obtaining a crypto loan is liquidity without requiring the borrower to sell their digital assets. Thus, the user doesn’t have to sell their crypto while still getting the necessary funds.
- Easy access to money. Borrowers can receive funds in minutes because crypto lending is a decentralised and automated process.
- Taxation benefits. Crypto loans may be regarded as a non-taxable profit in many countries. This can be a huge advantage for borrowers who seek to avoid triggering capital gains taxes by selling their crypto holdings. Such a loan means you don’t have to pay an additional fee because of the process of selling crypto, which is considered a gain and must be included when filing taxes.
- Flexibility. This option allows borrowers to use a wide range of cryptocurrencies as collateral and offers a variety of loan terms and repayment options. Thus, it’s a much more flexible solution, even though the process involves risks because of crypto volatility.
- Lower interest rates. While interest rates on cryptocurrency loans are typically higher than those on traditional loans, they can be lower than those on credit cards. Moreover, when a user has a bad credit history, most financial institutions that offer loans do so only after imposing higher rates.
The bottom line is that borrowers can use their crypto holdings as collateral and gain necessary financial support. Once they have money to repay the debt, they get their crypto back.
Despite the numerous advantages of crypto loans, there are quite a few drawbacks to taking on crypto loans. These are as follows:
- Cybersecurity issues. Because cryptocurrency transactions are online, there is a risk of data breach and theft. Borrowers should take precautions to secure their accounts and ensure that the platform they use has strong security measures.
- Volatility. The volatility of the cryptocurrency market is one of the most significant issues of crypto lending. If the borrower’s collateral loses value, they may be compelled to produce additional collateral or risk having their collateral sold.
- Transparency issues. Some cryptocurrency lending platforms don’t disclose their fees, interest rates, and other terms and conditions. Before choosing a platform, borrowers should carefully research the platform’s conditions.
- Little to no regulations. Users may face risks because the crypto loan business is mostly unregulated. Before taking out a loan, it’s critical to select a reputable platform and thoroughly research the terms and conditions.
- Margin calls. It’s one of the biggest problems when using less popular cryptos or taking a loan during a market crash. If the borrower’s collateral’s value falls sufficiently, they may receive a margin call. This procedure requires them to submit extra collateral or risk having it sold.
The bottom line is that users must be careful when choosing the platform and crypto as collateral. It’s critical to evaluate risks and benefits before making a decision.
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