What is a crypto loan?

A crypto-backed loan allows traders to receive liquid funds without selling their cryptocurrency. Instead, they use their digital assets as collateral for a cash or stablecoin loan.

Individuals may choose to take out a crypto loan instead of selling because they expect their crypto asset’s value to increase or because they want to hold the asset long enough to avoid short-term capital gains crypto tax rates.

How to get a crypto loan

Crypto loans are available through a crypto lending platform, as described above. Essentially, a crypto loan allows you to borrow against crypto. To get a crypto asset loan, you’ll need to own one of the cryptocurrencies accepted by the crypto lending platform you select. So first, check with the crypto lending platform regarding which coins they’ll accept, as that’s an essential part of finding the best crypto loans for your purposes.

Each crypto lending platform will have a unique application process, so it’s important to do your research before applying to make sure you’ll qualify in your region. Like any loan, the fine print matters, so take the time to read the terms and conditions.

Once you’re confident you’ve chosen the best crypto lending platform for your goals, start an account and begin the application process. You’ll need to verify your crypto holdings and your identity. From here, you’ll choose the type of crypto loan you want and the loan-to-value (LTV) you’re interested in, as well as payment terms.

Is crypto lending a good idea?

There are a number of benefits to crypto lending, including:

  • Low interest rates, often below 10%
  • Typically, no credit check
  • Fast funding, even within hours

Crypto loans, when properly handled, can be a quick and safe way for crypto holders to access additional funds by borrowing against their existing crypto holdings.

Crypto-backed loans give crypto holders access to capital without having to sell their crypto, which can be advantageous for tax and other purposes when used responsibly as part of a broader crypto strategy.

Pros and cons of crypto loans

Pros

  • No credit checks: Unlike conventional loans, crypto loans typically do not necessitate stringent credit checks.
  • Swift approval and funding: The process of approval and fund disbursement is known for its speed and efficiency.
  • Preserves crypto holdings: You can secure a crypto loan without liquidating your valuable cryptocurrency assets.
  • Flexible loan terms: Crypto loans often come with flexible terms, accommodating your specific requirements.
  • Low interest rates: Enjoy competitive interest rates.
  • Diverse utilization: You have the freedom to utilize the borrowed funds for a wide range of purposes.

Cons

  • Ownership of crypto is required: To apply for a crypto loan, you must possess cryptocurrency assets.
  • Increased LTV demands: Should the value of your crypto holdings decrease, you may be required to provide additional assets to maintain a healthy Loan-to-Value (LTV) ratio.
  • Risk of asset liquidation: Failure to make payments or repeated missed payments can lead to the liquidation of your assets.
  • Limited oversight: Crypto lenders typically operate with less regulatory oversight compared to traditional banks.
  • Lender reliability concerns: Borrowers are exposed to the risk of losing their cryptocurrency if the lending platform experiences financial difficulties.
  • Limited control: When you entrust your crypto to a Centralized Finance (CeFi) lender, you may lose control over your assets for the duration of the loan.

Types of crypto loans

There are two principal categories of crypto loans: custodial (CeFi) and non-custodial (DeFi).

  • With CeFi crypto loans, a central entity holds the collateral and controls the assets’ private keys, restricting the trader’s access to their assets.
  • DeFi crypto loans use smart contracts to enforce loan terms, allowing users to retain control of their assets unless they default on the loan.

Custodial crypto (CeFi) loans

CeFi loans are custodial, which is to say, a central entity takes custody of collateral. In this situation, a trader cannot access his or her collateralized assets. Instead, the lender controls the assets’ private keys. This contrasts with the more transparent DeFi loans, through which traders can see their assets’ availability directly on the blockchain.

The takeaway here is that although custodial crypto loans are still far more accessible and affordable than traditional loans, they still depend on a centralized lending provider to enforce their terms.

Non-custodial (DeFI) crypto loans

DeFi loans like that Aave and Compound offer are non-custodial. Rather than depending on a central organization to enforce the loan terms, they depend on smart contracts. If a trader takes out a DeFi crypto loan, they retain control of their assets’ keys—unless they default on the loan.

DeFi platforms cannot directly lend fiat currency. Instead, traders receive stablecoins that can then be exchanged for cash. DeFi loans tend to have a higher interest rate than custodial loans. DeFi, however, is more transparent than CeFi. For cryptocurrency holders who want to actually hold their assets’ keys, DeFi crypto loans are a must.

When to borrow against crypto?

Compared to the process of applying for a traditional loan, applying for a crypto loan requires relatively little. Credit checks are typically not required and instead, the amount of the loan you will be approved for depends upon the amount of collateral you’re able to use.

The loan-to-value (LTV) ratio is the ratio between the amount of the loan and the value of the collateral. If you put up $10,000 worth of crypto as collateral and receive a $6,000 loan in fiat or a dollar-pegged stablecoin such as USDT, your loan’s LTV ratio is 60 percent.

Because crypto markets are volatile, LTV ratios on crypto loans are typically low. There is always risk involved in borrowing, so do your research to determine what LTV you’re comfortable with.

What are the risks involved in crypto loans?

Finding the best crypto loans for your purposes begins with understanding the risks involved. Unlike assets held in traditional financial institutions, crypto accounts are not covered by the FDIC.

Consequently, crypto assets have no federal insurance if an exchange fails. With this in mind, three primary types of risk are inherent in crypto loans.

Technical risks of crypto lending

As in all cryptocurrency trading, there is a risk that protocols break down because of a technical problem or hacking. This risk is somewhat higher in non-custodial loans since all DeFi activity is completely algorithmically governed.

Counterparty risk of a crypto loan

The FDIC requires all traditional banks to maintain a certain level of liquidity; crypto loan providers are not subject to this requirement. If the market crashes, an unexpectedly large number of clients default on their loans, or if a platform breaks or is exploited, the crypto lending platform may find itself without the liquidity to return a borrower’s collateral.

Margin calls and forced liquidations

To prevent illiquidity during market downturns, lending platforms will issue margin calls or force liquidations. If a cryptocurrency’s value drops to a point where many borrowers’ LTVs are too high for the platform to maintain, the platform will inform borrowers that they must increase the value of their collateral or risk liquidation.

If the call is not met, the platform may liquidate enough of the collateral to bring an account’s LTV back to the maximum allowed ratio. In this case, a trader will have forfeited that portion of their deposit, will have incurred capital gains or losses, and may be charged transaction and broker fees.

Crypto loans without collateral

Crypto loans without collateral are in their early days. DeFi protocols such as Aave, dYdX, and Uniswap (as outlined above) offer uncollateralized flash loans. Flash loans allow users to borrow tokens or coins for a short time to perform specific transactions.

Flash loans are borrowed and returned within seconds using smart contracts that define the terms and conditions. If the borrower fails to repay or meet the contract conditions, the transaction is reversed and the funds return to the lender.

Investors typically use flash loans for arbitrage, through which they buy from one market and sell on another to profit from marginal price differences. Even a 1% price difference can lead to substantial gains with a large enough flash loan. Aave, for example, issues millions of dollars in flash loans daily.

There are a small number of crypto lending platforms that offer crypto loans without collateral for certain borrowers. For instance, Atlendis provides such loans to approved institutional traders.

It’s essential to exercise caution and do thorough research before engaging in any crypto borrowing. This space is still new and attracts scammers, and crypto loans without collateral pose special risks for investors. A good general rule is: if an offer sounds too good to be true, it probably is.

How are crypto loans taxed?

If a crypto loan is managed properly and all parties uphold the terms of the loan, the parties should not incur any taxes. The IRS considers cryptocurrency to be property, and using your property as collateral for a loan is not considered a cryptocurrency trade or sale and therefore is not a crypto taxable event.

However, several potential crypto loan scenarios could affect your taxes.

Crypto loan fees

Providers charge borrowers interest fees on their loans. These fees can range from around .5% APR to over 12% APR. If you use your loan for investment or business purposes, you may be able to write off these interest fees on your taxes.

Contact a tax professional for more guidance about business deductions.

Failure to pay back the loan

If you don’t pay back your crypto loan, the lender may liquidate all or part of your asset to recoup its losses. This could result in capital gains or losses for you, even though the lender retains the proceeds.

Forced liquidation

As mentioned above, if collateral is liquidated because of an unmet margin call, the borrower will be subject to capital gains tax on any increase in the collateral’s value between the time of its purchase and the time the lender sold the asset.

Self-repaying loans

Self-repaying loans, like those offered on Alchemix, do result in taxes owed. This is because the structure results in what is called “debt cancellation income.”

What can a crypto loan be used for?

Crypto loans offer a versatile financing option with considerable flexibility, often devoid of the constraints imposed by traditional lenders, akin to personal loans. The funds acquired through a crypto loan can be directed towards various significant expenditures, including a down payment for a house, a dream vacation, debt refinancing, or even the launch of a new business venture.

Crypto loans can be a logical choice for individuals who possess a substantial crypto portfolio and wish to access liquidity without resorting to selling their digital assets. This strategy proves particularly beneficial when concerns about crypto market volatility or fluctuations in coin values come into play.

Crypto loan alternatives

Several options are available for those hesitant to use their cryptocurrency as collateral. These alternatives provide diverse avenues for obtaining a loan based on different assets or financial instruments.

  • Consider a conventional loan offered by banks or credit unions. While this process typically involves a thorough credit check, it provides a traditional and established means of securing a loan.
  • Platforms like CashApp offer a convenient solution for individuals seeking smaller loan amounts. These apps allow borrowers to access loans ranging from $20 to $200, providing flexibility for those needing modest financial assistance.
  • Another option is a home equity loan, with which you use your home as collateral. However, default on a home equity loan can result in the lender seizing your home.

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