The rising popularity of cryptocurrency and decentralized finance as a whole has brought with it some remarkable possibilities. The ability to borrow against crypto, for instance, is undoubtedly changing the future of taking out loans.
Here, we discuss the pros and cons of borrowing against crypto and what the process looks like so you can make informed decisions when it comes to utilizing your assets.
How To Borrow Against Crypto
When you take out a crypto loan, you are borrowing against your crypto to access part of its value in fiat currency. Once you lock your assets with a crypto exchange as collateral, money is provided and paid back over time along with interest.
Of course, this is a slight oversimplification. While borrowing against crypto is designed to be easy for users, there are several nuances throughout the process and consequences in place if you fail to pay this money back.
Before we discuss the process in a bit more detail, let’s take a look at how you would borrow against crypto in the first place.
Selecting An Exchange
Borrowing against crypto requires partnering with a crypto exchange, like Vauld. The purpose of the exchange is similar to a traditional bank’s role in providing a loan, with a few notable differences.
If you were applying for a loan the traditional way, you’d walk into a bank to meet with a loan officer or review your options online. You’d find which loan works best for you, apply for the loan, and wait a few days for your application to either be approved or rejected.
If the loan is approved, then it can take up to a week for the funds to come through, and a denied application means starting over. Borrowing against crypto instead eliminates the wait and anticipation entirely. The approval and the loan are almost immediate.
The crypto exchange still takes on the most basic role of a bank by providing you with your requested loans. Rather than requiring background checks and lengthy approval processes, the exchange only cares whether you have the necessary assets to receive a loan.
The simplicity of this process is part of why it’s so important to select the right crypto exchange when borrowing against crypto. Seamless communication and a clear understanding of the process will help prevent overborrowing and other issues.
All of the best crypto exchanges will have a long list of available tokens to borrow against for all crypto endeavors. Diversifying your portfolio with an exchange that offers a range of crypto options means you’re more likely to get even better rates.
Choosing Your Crypto
Once you have selected the right crypto exchange and set up an account, it’s time to decide which token to borrow against. Depending on which token is held as collateral, you may end up with some of the best borrowing rates of around 4% to 10% or higher.
Bitcoin, for example, has a borrowing rate of 7.50% at the time of this writing. DAI, on the other hand, is near the higher end of 13%. In many cases, rates may fluctuate based on supply and demand.
The difference in rates will depend on the exchange, the volatility of the token chosen, and the loan-to-value ratio.
Loan-To-Value (LTV) Ratio
A significant factor in determining the interest rate you receive as a borrower is the loan-to-value (LTV) ratio. This is the ratio of the loan to the value of the collateral. You will have multiple options for which percentage you would like to borrow.
Let’s say you decide to borrow against Ethereum. If you want to borrow $3,000 in USD and the LTV is 50%, using the formula LTV = (loan amount)/(collateral value), the required collateral would be about $6,000 in ETH.
The interest rate given will ultimately depend on the LTV ratio selected, and a higher deposit will mean a lower LTV ratio and a lower rate. Common ratio options are 50%, 33%, and 25%. Here at Vauld, you can borrow up to an LTV ratio of 66.67%.
To reduce the risk that a lender takes on, overcollaterization is generally required by all exchanges. This allows lenders to account for potential depreciation of the collateral’s value.
The percentage of the loan secured by a discounted asset (the way a lender views your collateral’s value) is known as the collateralization ratio. This ratio can be determined by using the formula collateralization ratio = (collateral value)/(loan value).
It is not uncommon for collateralization ratios to be 300% or higher when borrowing against crypto. This is because the lower the ratio the higher the risk for lenders, and vice versa.
With the absence of credit scores in DeFi, a goal of many industry leaders is to develop a “crypto credit score” to lower the collateralization ratio without increasing risk to the lender. At Vauld, our fixed-term loans help reduce this ratio for borrowers.
Receiving Your Loan
Once you have agreed to the terms of your loan, accessing your funds is almost immediate in most cases. At Vauld, it’s instant. Compared to traditional bank loans, this can feel like skipping to the front of an otherwise long and tiresome line.
But what happens after the loan is received and you begin to pay it back in the agreed installations? While taking advantage of the benefits that come with this innovative process, there are still potential downsides to consider as well.
We’ll discuss both the pros and cons next.
Pros Of Borrowing Against Crypto
Along with low interest rates, quick access to funds, and diversification opportunities, other benefits of crypto loans appeal to a wide range of people, especially those looking to transition away from traditional finances or those trying to obtain a loan at the best possible interest rate.
No Bank Account
While omitting the need for a bank account may seem to some like an odd benefit, for many, the advancements in borrowing against crypto represent a shift closer toward a decentralized financial system.
A primary goal of decentralized currency is to provide you with more control over your finances and omit the need for third parties or intermediaries, such as banks. For those interested in this goal, this is one more financial engagement that does not require a bank.
No Background Checks
If you’ve ever applied for a loan only to be rejected, you know how burdensome it can be to have an obstacle like less-than-ideal credit impact the ability to get financial assistance. Crypto loans are significantly more accessible.
As previously mentioned, the exchanges that hold you accountable for the loans you take out only care whether the required assets are available for a loan. After this point, the responsibility of you as a borrower is the only thing standing between you and your crypto.
Cons Of Borrowing Against Crypto
There are many factors to consider when deciding whether to borrow against crypto. From insurance limitations to the relative newness of the process, this innovation can quickly become a nightmare if you aren’t careful.
If you’ve ever heard the term “crypto,” you’ve likely heard “volatile” associated with it at some point shortly after. Since nearly everything related to this industry is new and still evolving, the highs and lows are inevitable.
While there are other elements contributing to this, general uncertainty regarding crypto’s future plays a key role. The crypto that is being borrowed against can fluctuate due to this volatility, causing undesired consequences, such as margin calls.
At some point during the repayment period of a crypto loan, you might receive a margin call from your exchange. This means that your LTV has reached a certain percentage that requires you to add more crypto to comply with the minimum loan coverage.
While the specifics surrounding margin calls will be disclosed in the loan agreement, it can be discouraging to receive this request. You may not have the required additional crypto on hand, and adding more collateral can feel like there is now potentially more to lose.
Still, the plan for both you and the lender is that you will eventually end up back in possession of all your assets. The consequences of not depositing more crypto after a margin call paints a grim picture.
If the margin call isn’t met and the price continues to rise, then there is one more threshold known as Liquidation LTV. At this point, a portion of your assets will be liquidated to cover the margin call. The assets you expected to get back in full are now being depleted.
Because of margin calls and liquidation, it’s important to not overborrow. To account for a potential margin call, we recommend reserving cryptoassets in case more collateral is needed. This will help avoid liquidation and prevent any unnecessary losses in funds.
Should You Borrow Against Crypto?
Borrowing against crypto is one of many ways to participate in the growth of decentralized finances and build your wealth. When the disadvantages of volatility are considered, the benefits of cost savings, diversification, and expedited approvals can begin.
The most important thing to keep in mind when borrowing against crypto is choosing the right exchange and fully understanding the terms of the loan. At Vauld, we provide seamless communication so all customers can take advantage of the benefits crypto has to offer.
For any questions that arise throughout the repayment period, you can easily reach one of our representatives via our homepage.
At Vauld, we make it simple to successfully reach your financial goals with crypto. Sign up today and discover the difference that competitive rates, continuous upgrades, and customer-first values can make.