- Cryptocurrency (or crypto currency) has been increasingly popular for investors and even as an accepted payment at businesses around the world.
- As it gains popularity, cryptolenders are becoming more common as an alternative source of small business and personal lending.
- Find out more about cryptolending and the rise of digital currencies from Nav’s small business experts.
What is Cryptolending?
Cryptolending (or crypto lending) is the process of using crypto currency, such as Bitcoin (BTC), as collateral, as you would with a secured loan. It’s a decentralized finance (or DeFi) service that uses the blockchain to lend crypto assets to borrowers and then get crypto interest. For a cryptolender, it can be compared to opening a high-yield savings bank account, where you earn interest on the money in the account, but using crypto currency instead.
It sounds straightforward and like a great deal, but because digital currencies are still new and the crypto market isn’t necessarily always stable, it’s not common for traditional lenders to participate in cryptolending yet. However, cryptolending is quickly becoming one of the most popular DeFi services on cryptocurrency platforms and exchanges.
How Does Cryptolending Work?
With cryptolending, lenders and borrowers use a crypto platform or exchange as a lending marketplace. Both will sign up to the platform using their digital wallets. To engage with cryptolending, a cryptolender will move their cryptocurrency from their digital wallet, or crypto wallet, into a high-interest lending account on the platform. Borrowers can then apply for cryptoloans through the platform, which will approve the borrower and set interest rates and fees. The loan will be paid for using funds from the cryptolenders’ accounts. As the borrower repays the loan through monthly payments, the cryptolender and the platform will collect the interest.
Every platform will have its own interest rates and fees. Lenders may get a higher annual percentage yield (APY) if they’re willing to keep their cryptocurrency locked into the account for a certain amount of time without making withdrawals, giving the platform more access to the funds for lending purposes.
There are also automated methods for cryptolending. In this scenario, borrowers and lenders simply connect their digital wallets to a centralized lending protocol which handles the approvals and transfers based on certain conditions being met. These conditions are called smart contracts, and they’re made up of code running on blockchain networks that automatically determine when a loan can be approved.
Pros and Cons of Using Crypto as Collateral
As with any financing, there are risks associated with cryptolending. There are also pros and cons:
Pros
Pros
- No credit check for borrowers
- Can be used by borrowers who may not qualify for other loans
- Often offer lower interest rates than traditional loans
- Lenders gain passive income on crypto holdings
- Lenders can get higher interest rates than other savings accounts
Cons
- Cryptolenders aren’t insured by the Federal Deposit Insurance Corporation (FDIC) so lenders are at higher risk of losing their money
- Borrowers can be asked to have a loan-to-value ratio (LTV) of up to 50%
- Liquidity issues can make it hard to sell the borrower’s collateral fast enough to cover the principal, meaning both the lender and borrower lose money
- If you use a stablecoin, the value of your collateral is dependent on the value in U.S. dollars (USD) of the cryptocurrency you use
Is Crypto Collateral Good for Bad Credit?
One of the reasons that cryptolending is popular is because it doesn’t require a credit check like more traditional forms of financing like a personal loan or business loan. This means that borrowers who have a less than stellar credit score can borrow through cryptolending. This can be particularly tempting for entrepreneurs who are looking for small business startup loans because they don’t have business history or business credit scores yet.
But even in cryptolending, having a poor credit score can make borrowers more likely to fall prey to high interest rates and short-term repayment agreements. It’s a good idea to learn how to establish business credit and improve it over time, especially if you are interested in small business loans. You may also look into business credit cards to help pay for business expenses and build your credit over time.
The Risks of Cryptolending
Cryptolending comes with a range of risks.
- Volatility — Cryptocurrencies are known for having huge price increases and decreases depending on the whims of the market. Because of this volatility, they’re considered less stable than other currencies and this can make your loan complicated.
- Counterparty credit risk for lenders — There’s a chance in any lending scenario that the borrower will default on the loan and not be able to make their final payments, but it’s particularly high with cryptolending.
- Platform insolvency — Because of the volatility that we mentioned above, cryptocurrency platforms can go bankrupt at higher rates than FDIC-insured banks and traditional lenders. It’s unlikely that the lender or borrower will be able to get their money back if a platform goes bankrupt, either.
- Security issues and cyber attacks — Because cryptocurrency is managed completely through digital means, it’s a prime target for hackers. The most popular currencies, like Bitcoin and Ethereum (ETH), are often at risk of cybersecurity attacks from outside. Also, newer cryptocurrencies may not have as strong security features for your digital assets, which puts you at risk.
- Technology failures with smart contracts — New technology often has a lot of kinks to work out, and smart contracts are susceptible to coding errors if they’re put together hastily or unregulated. This can lead to errors that are similar to banking errors, like too much money put into or taken out of your account.
- Unclear regulations — Laws and regulations around cryptolending and cryptocurrency in general are still being written. It’s a bit like the Wild West, and because the legal issues aren’t clear, it can mean you won’t have much recourse if things go wrong.
Best Cryptolending Platforms
Because cryptolending is new and still developing, it’s hard to say what platforms are tried-and-true. However, there are certain standards you can use when looking for a good cryptolender, including:
- Good security (like encryption)
- Lower interest rates and fees for borrowers
- Flexible term rates for loans
- Multiple currency support (e.g. for both BTC and ETH)
- Low(er) risk of platform insolvency
- Deposit limits (for lenders)
Here are some cryptolenders that meet these criteria:
As always, check with each lender for loan terms and conditions, and, in the case of cryptocurrency and cryptolending, read up on the platform to make sure they’re not in hot water.
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This article was originally written on August 31, 2022 and updated on September 2, 2022.
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