Like a house, car, or other investment, your cryptocurrency can serve as collateral for crypto loans, which are loans that may have low interest rates, same-day funding, and no credit checks.
The wrong side? If the value of your crypto drops, you may need to pledge more crypto.
“This will be the biggest downside to crypto,” says Travis Gatzemeier, certified financial planner and founder of Kinetix Financial Planning near Dallas. “It’s not a normal, stable asset that you use to borrow.”
Despite the risks, cryptocurrency – and the borrowing against it – have become popular topics on public forums like Reddit and YouTube. But is a crypto loan right for you?
What is cryptocurrency?
Cryptocurrency entered the financial dialogue in 2008, with an anonymous programmer’s white paper on the concept of bitcoin.
Bitcoin is a cryptocurrency, or a digital form of money. It might sound complex – and depending on how you use it, it can be – but it’s basically digital tokens as opposed to physical money. It can be exchanged for goods and services on the blockchain, which is a digital ledger that keeps track of every bitcoin transaction.
“The idea is meant to be fairly simple,” says Ariel Zetlin-Jones, associate professor of economics at Carnegie Mellon University in Pittsburgh.
Throughout history, we have accepted physical tokens in exchange for goods and services, believing that we can then exchange those tokens for money for other goods and services in the future. Blockchain and bitcoin facilitate the same type of transactions but without the need for physical tokens, explains Zetlin-Jones.
What is a crypto loan?
A crypto loan is a type of secured loan, similar to a car loan, in which you pledge an asset to secure funding.
In this case, cryptocurrency is the asset offered to a lender in exchange for money that you will repay in installments. If you don’t repay the loan, the lender will liquidate or cash out the cryptocurrency.
Crypto lenders like BlockFi, Celsius, and Unchained Capital have relatively low annual percentage rates and loan terms of one to three years, but high minimum loan amounts.
For example, BlockFi’s crypto loans start at 4.5% APR on one-year loans, but the minimum loan amount is $ 10,000.
Why borrow against crypto?
A crypto loan can make sense if someone holds a substantial amount of crypto and wants to liquidate it without having to sell and possibly pay taxes on it, explains Gatzemeier.
These funds could then be used for a purchase or to invest in a business, much like borrowing with a personal loan.
Additionally, borrowers might see lower interest rates with a crypto secured loan. And unlike personal loans, there is no credit check.
The problem with crypto loans
From April 2021 to October 2021, the price of bitcoin fluctuated between around $ 30,000 and $ 64,000.
The volatile value of the crypto can lead to a margin call, where the borrower has to put in more crypto in order to maintain the value of the initial commitment.
If the value of your pledged crypto drops below a threshold set by the lender, you have a limited time to pledge additional crypto.
In cryptographic parlance, the ratio of the loan amount to the value of your collateral is called loan-to-value or LTV. For example, the maximum LTV of crypto lender BlockFi is 70%. At this threshold, borrowers have 72 hours to raise the crypto.
In addition to volatile prices, crypto loans are also not federally insured, explains Gatzemeier. If you lose your funds in a security breach, for example, compensation is not guaranteed.
Alternatives to borrowing against your crypto
If you have equity in your home: With a home equity line of credit, you can potentially borrow up to 85% of the value of your home. Be careful, however, because you can lose your home if you don’t pay it back.
If you are looking for a lower interest rate: A 0% interest credit card can offer free financing for 14-18 months. However, note that after the introductory period, you may be paying a high interest rate on overdue balances.
If you have bad credit: Loans from credit unions usually have flexible rates and terms. They also take into account your history as a member, which means they may have more flexible requirements.
If you need a small loan: A small personal loan – less than $ 2,000 – is also a viable option. However, the rates can be high depending on your credit profile and income.
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Chanell Alexander writes for NerdWallet. Email: [email protected]
The article Crypto Loans Unlock Cash, But They Carry Risks originally appeared on NerdWallet.