Taking Loans in Cryptocurrencies
From a personal finance perspective, there is good debt and there is bad debt. Bad debt typically costs a lot and requires more money that could be used for long-term investments. Good debt, in contrast, may be low-cost and used for the purchase of a productive asset. Good debt is usually used to build wealth — even by those who are conservative investors. Loans in cryptocurrencies can also be considered as good debt, despite the associated risks.
Loans in Cryptocurrencies
Crypto-backed loans are similar to a mortgage in that the value of your cryptocurrency can be borrowed against. You may receive money in relation to the crypto-assets that you already own. By borrowing against the assets you own, you gain several advantages. One of the advantages lies in the fact that if prices of investments rise in the future after taking out a loan, the total value of your assets increases. Also, you are able to avoid triggering a taxable event. If you are able to make capital gains in crypto-assets, you typically have to pay taxes.
However, if you take out a loan to make investments, the interest charged to you on the loan can be deductible against other capital gains that you have in the same year that you incur the interest expenses. As an example, if you were able to buy Bitcoin at $4,000 and decide to use it to get a loan from a crypto-loan provider, you could receive an amount equivalent to 50% of the value of your holdings. If the amount is invested and increases in value, gains made on it would not trigger a taxable event.
Lending in the crypto ecosystem presents utility value for Bitcoin. Few other assets in the world allow one to receive debt financing as cryptocurrency does within a lending system. Regardless of location, financing is possible in ways that have never been before.
Credit Scores and Crypto Loans
Unlike a traditional loan, a crypto-loan does not typically depend on one’s credit score. Some customers may find themselves applying for mortgages while also in need of loans for other purposes. In such cases, it is more ideal to not have loans that affect their credit report. Such loans can make it harder to apply for mortgages. This means that one can take a crypto-loan with little worry about how their credit report can be affected. Also, it gives access to loans for those who may have less than favorable credit ratings.
"Fluidity’s upcoming mortgages will use smart contracts and cryptocurrency for back-end management. Lippiatt told CoinDesk his startup is currently exploring partnerships with ethereum-centric lending platforms, such as MakerDAO’s dollar-pegged DAI loans." @fluidityio 💪🏡 https://t.co/SuLwHW2YGY
— Maker (@MakerDAO) May 9, 2019
The loan-to-value ratio of a crypto lender is affected by different factors. It is important to take such factors into consideration when choosing a lender. The current market price for cryptocurrencies is one of the most significant factors that affect the loan agreement. Some lenders may use different indices to determine the market price. For example, some organizations choose to calculate market prices from only a select few exchanges. Others, however, use a wider variety of exchanges to calculate market prices of cryptocurrencies.
Market Volatility and Collateral Risks
Where downside market volatility is experienced, events in the loan agreement may be triggered. For example, if the value of collateral drops, a margin call would be executed which involves informing borrowers to add more assets as security to cover for the loss in value of their asset and pay down the loan principal. If no action is taken and price falls further, a portion of the collateral may be sold to pay down the loan balance. The purpose of this is to mitigate risks tied to the loan balance in unfavorable market conditions.
It is important to consider the partners of a crypto-lender as your collateral is exposed to certain risks of losses when you place it with a lender in the ecosystem. Lenders may choose to partner with specialists in crypto-custody in order to keep the assets of borrowers safe until they repay the principal.
The repayment terms should also be given strong consideration when determining which lender to take a cryptocurrency loan from. BlockFi, for example, requires interest-only payments throughout the duration of the loan. It does not subject users to prepayment penalties. It allows clients to set automatic payments. If auto payments are not set up, it may automate the sale of a clients’ collateral to pay off a loan.
A Bright Future but Rocky Path for Loans
As time passes, more varieties of loans will spring up in the cryptocurrency sector. More native crypto-firms will offer new types of digital currency loans. Also, more mainstream tech firms will provide new lines of credit through cryptocurrency. With more entrants in the markets, things can become quite noisy. In order to discern between worthy lenders and non-worthy lenders is to consider the track record of compliance that companies have. This sheds light on what their priorities are and how far they are willing to go to protect their clients.
Some lenders, after having raised large funds from ICOs place significant emphasis on users using their utility tokens to gain advantages on loans. These tokens, in some cases, present challenges to user experience. Many users would rather directly get a loan than purchase a token in order to get a better-priced loan.
If you aren’t so sure about whether or not you would like to get a crypto-loan, you can always test the waters by providing money to a lender in return for interest. You would essentially be acting as a lender to a lender who has the infrastructure and scale to distribute loans to borrowers. Some lenders would give you 6% or more annually if you place your cryptocurrency with them. If you deposited 1 Bitcoin on January 1st with a lender, you could have 1.062 Bitcoin in your account as interest compounds over the period.
The decentralized finance ecosystem shows the light and darkness of the industry in that it was able to lock in over $1 billion dollar in value in early 2020 but due to recent shocks to the cryptocurrency markets, major decisions had to be made to reduce liquidity risks. One of such decisions involved the introduction of USDC stablecoin as an accepted collateral by MakerDao. This is another reminder of the great opportunities for profit in the ecosystem which have also been matched by great risks.