Is borrowing against crypto better than traditional lending? People today want to invest in crypto to earn handsome returns but holding crypto coins may also provide you with the money you need.
Now, you have different sources out there to borrow the money required to make your investment such as traditional lending and borrowing against crypto.
But the question is whether borrowing against crypto is a better idea than traditional lending.
Well, just like any other forms of also come with several risks characteristic to it.
Here is an article that will not only let you know about these risks but will also make you knowledgeable about crypto loans as much as possible.
Going through this article you will come to know the different types and working process of crypto loans, a few good reasons to take out a crypto loan, the pros and cons, as well as some alternatives to it.
With such knowledge it will be much easier to make your choice and a more informed decision.
Typically, a crypto loan is not like using a stable and normal asset to borrow.
In a crypto loan, it is your cryptocurrencies that act as the collateral for the amount borrowed, just as your house or car.
A few good things about crypto loans that make people go towards it includes and is not limited to:
- Low interest rates
- No credit checks and
- Same-day funding.
And, for the significant downside of it is that, crypto being extremely volatile, the value of the coin may fall, In that case you will probably have to put in more crypto as collateral.
But, is crypto loan right for you? To know, read on.
Is Borrowing Against Crypto Better Than Traditional Lending?
In spite of its downsides, crypto, and borrowing against crypto is quite a popular topic for discussion right now among crypto users and on several public forums such as YouTube and Reddit.
If you are ignorant about it, you will be surprised to know that crypto loans can come with an interest rate ranging between 5% and 15% depending on its type and the lending policies of the lender.
For that, you do not need to pledge your home or car as collateral.
And, you will not even need to pay any processing fees or submit any kind of documentation and wait for a long time to get your loan applications approved.
You can have the amount you want to borrow transferred to your digital wallet almost instantly.
It is for all these beneficial features that crypto loans have become so popular in just a couple of years.
In fact, with the kind of momentum it has gained over these years, it can spur an entirely new financial era.
Now you will not need to spend traditional fiat currencies to hold your crypto and remain invested.
You can do it easily by availing the facility of crypto lending or crypto-based financing.
What is a Crypto Loan?
As said earlier, you will have to pledge some crypto in order to borrow against it.
Therefore, a crypto loan is a kind of a secured loan and is pretty much the same as an auto loan or a home loan where you put in your car or home as an asset to secure the loan.
If you fail to make the repayment on time, the lender will recover the money by liquidating or cashing out the crypto coins held as collateral against the loan.
If you take out a crypto loan from a reliable source, which needs some research to find one, you may have to pay a comparatively low Annual Percentage Rates or APR.
And, you will get enough time, ranging anywhere between one and three years, to repay the borrowed amount.
However, the minimum loan amount may be quite high.
Therefore, before you take it out, you must be very sure that you really need the loan and will be able to repay it on time.
Typically, if you take out a crypto loan you will get either cash or crypto coins.
However, at this point it is important to keep in mind that though you will remain the owner of the crypto asset you pledge as collateral you will not be able to use it for transacting or trading during the loan tenure.
Looking at it from the other perspective, crypto investors who plan to hold their coins, or HODL them (which is a crypto term for Hold On for Dear Life), and do not have any plans to sell them soon typically lend crypto assets.
This allows them to earn some additional money in the form of interest during the lending tenure which is called ‘crypto dividends.’
Lending their crypto assets is a very simple yet useful way to generate some passive income by the crypto investors.
You can get a crypto loan from any crypto exchange or from any crypto lending platform.
Traditional lending, on the other hand, is also evolving rapidly with its improved debt structures such as P2P systems and crowdfunding.
A few systems have also incorporated blockchain platforms to facilitate crypto-denominated lending and borrowing.
Traditional global lending has been one of the most significant drivers of development of the economy since the time modern banking was introduced.
In simple words, traditional lending is a process where a lender usually gives money to the borrower.
Sometimes, property or other assets may also be offered.
These offers are made on the basis and belief that the borrower will repay the money or the asset borrowed in the future along with some additional amount called interest or the lender’s fee.
In more specific financial terms, the lenders extend credit to the borrower, who is called the debtor and is liable to repay the debt.
The interest charged by the lenders or the creditors acts as an incentive that motivates them to lend the amount.
Usually, in traditional lending, there is an intermediary, such as a bank or a financial institution, which facilitates the whole process.
These intermediaries are also the primary authority and their main job is to bring the lenders and the borrowers together.
Typically, the global banks depend on a fractional reserve banking system.
This framework needs a specific percentage of the deposit of the bank to be set which will serve as credit for the borrowers.
This small fraction of the deposits made in the bank is held as reserve at any point of time so that it can be loaned out.
However, there is a significant issue in the traditional lending system.
If a situation arises when most of the customers withdraw their deposits together at the same time the bank will not have any money in hand to reimburse the bulk of the consumers all at once.
This situation is called the bank run and can be very problematic not only to the lenders and the borrowers but also for the whole economy in the macro scale.
When it comes to the interest rates, it is usually the central banks that determine the benchmark.
However, for private lenders, other Financial Technology or Fintech and P2P lending platforms, historically they make changes in the rate of interest to compete with each other and win more business.
Not very long ago, in the traditional lending space, it was the banks and different credit unions that have been the primary source for the consumers to get credit.
However, over time, this dynamic has changed and now it has moved on to P2P lending and crowdfunding.
These sources along with the innovative financial technology have made financial services more convenient and easily accessible to the public at large.
However, all these services are still incorporated with the conventional banking system.
This means that they still use a centralized infrastructure.
Therefore, the features and functioning of the traditional lending system is much different from crypto lending.
Types and Working Process
When you look for the crypto lending platforms, you will come across two specific types of it such as:
- Automated crypto lending platforms – This platforms offer dividends as soon as deposits are made into the crypto wallet and
- Manual crypto lending platforms – These platforms need the investors to stake or block a certain number of coins for a specific period of time manually in order to get the dividends.
As for the working process of a crypto lending platform, it essentially involves exchange of digital assets in one way or the other.
However, it is the infrastructure underlying the crypto lending platform that will typically determine whether the working process is decentralized or centralized.
As for the decentralized peer to peer crypto lending platforms they fall under the sphere of Decentralized Finance or DeFi platforms.
These are typically non-custodial platforms and usually do not follow the regulatory protocols such as AML or Anti-Money laundering and KYC or Know Your Customer.
Apart from that, in this form of crypto lending, the borrowing and return rates typically reflect the demand and supply of the LP or Liquidity Pool underlying it.
This feature, most of the time, makes it quite difficult to predict these rates.
The decentralized crypto lending platforms usually have to compete with the centralized solutions.
In order to stay in the race, these platforms have to offer better features which include and are not limited to:
- Margin lending
- More attractive lending terms for the borrowers and
- More favorable rates of interest to the lenders.
Usually a decentralized crypto lending platform uses highly sophisticated and automated codes to manage almost the entire working process.
One such useful automated management tool is the smart contracts.
These contracts typically automate the payouts of crypto loans as well as generate the yields for the lenders.
This particular dynamic helps in assuring that these platforms are easily accessible.
These decentralized platforms normally need only the collateral to give out a loan which makes this process easier, more convenient and faster.
Once this collateral is deposited in the wallet, the loan can be received.
You can get these loans in different denominations, depending on the features and offers of the lending platform such as:
- GUSD and even
- Fiat money.
The decentralized crypto lending platform also generates and maintains a transparent and publicly distributed record.
This particular feature makes them extremely censorship resistant.
However, in spite of these specific advantages offered by the decentralized crypto lending platforms, consumer protection offered by them is pretty poor which may leave the users much more vulnerable when and if something goes wrong.
Moreover, the yields on these platforms are usually lower as compared to their alternatives.
A centralized crypto lending system, on the other hand, falls under the sphere of Centralized Finance or CeFi.
These particular platforms typically follow the infrastructure and regulations of traditional banking systems and lending processes.
This means that they will have almost every regulatory measure in place like the traditional lending platforms including AML and KYC.
These crypto lending platforms have the custody of the deposits of the customers and ensure that this collateral is safely stored, typically by incorporating cold storage solutions.
These platforms also offer insurance coverage on deposits sometimes.
Accessing these platforms and setting up an account can take a long time however, the benefits offered by them are much better.
These come in different forms such as better regulation, infrastructures, and lending policies that the traditional investors are more familiar with.
It is also important to keep in mind that, lending on a centralized crypto lending platform typically occurs on-chain but there is an intermediary that acts as the custodian and facilitates the whole process like traditional lending systems.
This means that, though deposits and withdrawals are registered on the blockchain underlying the platform the overall process is governed by humans.
No matter whichever system of crypto lending you go for, to make a crypto loan there needs to be three parties involved.
- The borrowers – They are the users who want the fund for different reasons pledging crypto or fiat assets to get the money.
- The lenders – They are those users who offer the crypto coins, stablecoins, or even cash and generate some additional passive income from it.
- The crypto lending platforms – They act as the third party that connects the lenders and borrowers and takes care of the process.
All the three parties typically involve in the crypto lending process which includes:
- The borrower making the crypto loan request and depositing the collateral
- The crypto lending platform accepting the request and deposits and attaching the collateral
- The lender funds the amount through the lending platform to the borrower.
The entire process happens on a blockchain network much unlike fiat lending which typically happens on a traditional Web 2.0 network.
Reasons to Borrow Against Crypto
Borrowing against crypto than taking on traditional loans makes a lot of sense sometimes.
It is especially beneficial if you hold a substantial number of coins in your wallet and want to liquidate them without needing to sell them off in the process.
Sometimes, you may even have to pay taxes on it.
You can use the funds received for investing in other businesses or purchase something using them just like a personal loan.
More importantly, crypto loans are very useful for the borrowers because these usually come with lower interest rates than a personal loan.
Risks and Problems
You may not be able to do away with the risks of taking out a crypto loan if you do not get well-acquainted with the platforms before using them.
Some of the significant risks of the crypto platforms are:
- Liquidity risk that you may be exposed to especially when you use a centralized crypto lending platform as a borrower due to the fall in value of the assets and a lender may also lose their original investment due to liquidation
- Risk of volatility in the interest rates when you use a decentralized P2P lending platform and the Liquidity Pool if and when a large amount of capital moves in or out of the platform
- Technical risks in a decentralized P2P crypto lending platform such as a code getting corrupted or the hackers exploiting the vulnerabilities of a smart contract to crash the platform or steal funds and
- Regulatory and taxation risks in both a centralized and a decentralized crypto lending platform if they do not adhere to AML and KYC protocols resulting in uncertainties.
Some other significant problems of the crypto loans include the chances of getting a margin call from the lender due to the decrease in value of the crypto assets held as collateral.
A margin call is the demand from the lender to a borrower asking to put up more crypto coins to retain the value of the collateral of the loan.
You will also have a very limited time from the lender to pledge this additional amount of crypto as and when it falls below the set threshold of the lender.
Sometimes this time limit to respond to the margin call can be as little as 72 hours to maintain your LTV or Loan to Value of your collateral.
And, most importantly, no compensation is guaranteed if, unfortunately, you lose the funds due to a security breach because these crypto loans are usually not federally insured.
Therefore, make sure that you are adequately informed and educated about the risks before you take on a crypto loan or else you may jeopardize your financial health altogether.
Pros and Cons
The crypto loans come with a few significant pros and cons, just like any other form of loans.
Apart from the significant benefits mentioned already at the beginning of this article, this type of loan can be very useful at the time when liquidation is needed.
It is due to the comparative ease of liquidity of both the collateral sources as well as the crypto platforms.
On the other hand, in a traditional lending system the process of liquidating is pretty lengthy in comparison.
Another significant benefit of crypto loans is the higher returns that these are known to offer to the lenders in comparison to a traditional savings account.
The lenders, as well as the borrowers, can leverage crypto while using a centralized or a decentralized crypto lending platform in order to increase their profits.
They can also make the best use of it to augment the productivity of their crypto assets.
On the other hand, one significant downside of crypto lending is that more often than not these loans need over-collateralization and the assets held can fall in value due to the wild price swings that are so common a thing to happen in the crypto space.
If you view it from the perspective of a lender then this is not an ideal or most favorable credit mechanism.
However, in spite of the downsides of it, down the lane, when crypto adoption will accelerate, more and more of these crypto lending platforms will emerge and make financial activity much easier through the decentralized economy.
There are some good alternatives to borrowing against crypto that you may try out.
For example, you can go with a home equity line of credit, provided you have equity in your home.
These types of loans will enable you to borrow funds up to 85% of the value of your home.
However, make sure that you have made enough arrangements to repay the loan on time or else you may run into the risk of losing your home.
Another good alternative to crypto loans is the 0% interest loan on your credit card, if you are especially looking for a loan with a really low rate of interest.
Typically, in this form of lending you will get free financing for anywhere up to 14 to 18 months.
However, you should be very careful about this free-time period, also referred to as the introductory period.
If you do not repay your loan in full within this stipulated time you stand a chance to pay a very high interest rate on the balances not paid by then.
You can also choose to take out a credit union loan if your credit score is not all that good, though in crypto loans there is no credit check made as well.
Typically, these loans offered by the credit unions come with very flexible lending terms and rates of interest.
The requirements by the credit unions are also pretty low because they normally loan out on the basis of the history of the member.
Finally, if you need to take a loan of a small amount, say less than $2,000 for example, you can take out a personal loan from a traditional lending source.
This is quite a feasible option provided you are okay with the relatively high rate of interest, which will vary depending on your income and credit profile as well.
Borrowing against crypto is gaining popularity with each passing day and now you know it is quite a reliable and useful way to get the needed money.
Therefore, if you do not want to take out a loan through traditional systems, you may take out a crypto loan.