What is crypto lending and how does it work?
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Cryptocurrency has enjoyed rising popularity and mainstream adoption in the U.S. and around the world. In November, cryptocurrency surpassed $3 trillion in market capitalization. About 16 percent of Americans have invested in, traded, or used cryptocurrencies. That’s about 40 million people who have begun venturing into digital currencies. Many digital currencies, however, are highly volatile in the short term. Bitcoin, for instance, doubled in value in 2021, only to lose practically all of its gains in just the first month of this year.
For cryptocurrency users who aren’t concerned about short-term volatility because they’re in it for the long haul are now using their digital assets as collateral for loans. Here’s what to know about crypto lending and some of the pros and cons to consider.
The most popular types of cryptocurrency
There are thousands of different cryptocurrencies available. According to crypto news outlet CoinDesk, here are the top five in terms of market capitalization:
- Bitcoin: The first cryptocurrency, Bitcoin was created in 2008 by Satoshi Nakamoto, a pseudonym used by the person or group of people who invented it. Bitcoin is by far the most popular and most valuable cryptocurrency. It trades as BTC on exchanges. As of 2021, about 114 million accounts around the world held Bitcoin.
- Ethereum: Ethereum is a decentralized, open-source blockchain that uses Ether (ETH) as its native cryptocurrency. Ethereum is the second-largest blockchain by market capitalization, having recently reached more than $368 billion. In addition, as of 2021, more than 71 million cryptocurrency wallets held some Ethereum.
- Tether: Originally known as Realcoin, this cryptocurrency is considered one of the “stablecoins.” Digital currencies categorized as stablecoins are directly linked to another asset. Tether earned this distinction because it was one of the first cryptocurrencies to peg its market value to a stable, flat currency. Users are able to redeem tethers for dollars. There are about 69 billion Tethers in circulation.
- XRP: XRP is the native digital currency for Ripple, a settlement system and payment network. The currency was created to reduce transfer fees and wait times for financial institutions. About 47 billion XRP coins are in circulation.
- Terra: Another “stablecoin” Terra was created by Singapore’s Terraform Labs, which was founded in 2018. Terra is considered stable because it is pegged to key currencies. TerraUSD is tied to the US Dollar in terms of value and is a scalable, and yield-bearing currency. Terra’s native token, Luna, has been surging in value with tokens more than doubling in price since the beginning of 2022 from about $44 in January to $104.58.
How crypto lending works
A cryptocurrency-backed loan uses digital currency as collateral, similar to a securities-based loan. The basic principle works like a mortgage loan or auto loan — you pledge your crypto assets to obtain the loan and pay it off over time. You can get this type of loan through a crypto exchange or crypto lending platform.
While you retain ownership of the crypto you’ve used as collateral, you lose some rights, such as the ability to trade it or use it to make transactions. Also, if the value of your digital assets drops significantly, you may end up owing back much more than you borrowed should you default on the loan.
People may consider crypto loans because of the benefits they provide and because they have no intention to trade or use their crypto assets in the near future. The acronym HODL, which stands for hold on for dear life, is a common refrain in crypto-focused online forums.
Benefits of cryptocurrency lending
Compared with traditional secured loans, crypto loans have unique features that can make them appealing for some crypto enthusiasts:
- Low interest rates: While they’re generally not as cheap as mortgage or car loans, crypto loans are an inexpensive alternative to personal loans and credit cards. You can often get a crypto loan with an interest rate below 10 percent.
- Loan amount is based on asset value: In many cases, you can borrow up to 50 percent of your portfolio value, but some exchanges go as high as 90 percent.
- Choice of loan currency: Depending on the platform and what you need, you can generally get the loan funds in the form of U.S. dollars or select cryptocurrencies.
- No credit check: Crypto lending platforms and exchanges typically won’t run a credit check when you apply, making it an incredibly attractive financing option for people with poor credit or no credit history.
- Fast funding: Once you’re approved, you can get your loan funds in as little as a few hours.
- Ability to lend crypto: Many crypto exchanges offer “interest” accounts that allow you to lend your own digital assets and receive a high APY — sometimes upward of 10 percent — in return.
Things to consider before engaging in cryptocurrency lending
There are some clear benefits to using your digital currency to secure a loan. But because of the nature of secured loans and cryptocurrency, there are also some downsides:
- Margin calls: A margin call occurs when the value of your collateral drops below a certain threshold and the lender requires you to increase your holdings to maintain the loan. In some cases, the lender may even sell some of your assets to cut your loan-to-value ratio. Because cryptocurrencies are extremely volatile in the short term, the chances of this happening can be high.
- No access to your assets: As long as your loan has an outstanding balance, you can’t access your holdings to trade or transact. This can be a significant problem if the price of the currency drops significantly or you need cash in a hurry.
- Repayment terms can vary: These loans usually function like traditional installment loans, and depending on the crypto lending program, you may have less than a year to pay back what you borrowed. In other cases, you can create your own repayment schedule. With shorter repayment terms, it’s crucial that you know beforehand whether you can afford the payments.
- Not all digital assets are eligible: Depending on the crypto lending platform you use, you may need to exchange your currency for an eligible asset. This may not be preferable if you want to hold onto your specific asset and it doesn’t qualify as collateral on any platform.
- Interest account funds aren’t insured: If you’re lending your own digital assets, the funds in a crypto interest account aren’t insured like the money in your bank account. So if the exchange fails, you could lose everything.
- Interest account withdrawals can be slow: You can generally request a withdrawal from your crypto interest account whenever you want. But depending on the platform, it could take several days for those funds to be released so you can use them. This can be very damaging if the value of your assets drops quickly and you can’t trade them.
The bottom line
If you need money and have sizable crypto holdings but don’t want to sell them, crypto lending can be an alternative worth considering. Crypto loans can be inexpensive and fast, and they often don’t require a credit check. Also, if you have digital assets that you plan to hold onto for a long time, lending them out via a crypto interest account could be an excellent way to maximize their value.
Before you engage in either side of crypto lending, though, it’s important to understand the risks, especially what could happen if the value of your cryptocurrency drops swiftly and significantly. If you’re considering crypto lending in either form, make sure you consider both the benefits and drawbacks, as well as all your other options, before you make a decision.