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Ask CryptoVantage: Should I Take Advantage of Crypto Loans?
Cryptocurrencies are incredibly versatile financial instruments. For example, did you know that you can get a loan by locking up your assets as collateral? For most of us, it is not immediately obvious why you would want to do this. In order to secure a loan, you must lock up your hard earned crypto. Wouldn’t it be easier if you just spent what you had?
When I was investigating what crypto loans were used for, I found answers to each of these questions and more. My aim is to give you a clear idea of when and why you would consider taking out a loan against your cryptocurrency.
Why Take on Debt in the First Place?
If you’re taking on debt, it is because you want something now, and are willing to sacrifice your future earnings to have it. Debt is money that comes from the future. There is utility to having the ability to borrow from your future self. You get money now, without parting with anything you already own.
The best case scenario when taking on debt, is ending up with more money than what you started with. This is only the case if the money you earn on top of the debt, exceeds the price of the debt. The price of the debt is the principal amount of money, plus the interest rate.
The Types of Crypto Loans You Can Receive
There are two main ways of getting access to debt within the world of cryptocurrency. The first is through centralized cryptocurrency businesses like Crypto.com or Binance. The second is through DeFi platforms like AAVE, MKR/DAI, and Venus. There are various tradeoffs to either solution, so it’s just best to be aware of what they are. Knowledge will allow you to pick the solution that best fits your financial needs.
Borrowing Through Centralized Finance (CeFi)
Nowadays, there are dozens of companies that will provide you with a crypto loan. Interest rates will vary depending on how much collateral you put down, and how much debt you take out. The benefit of getting a loan through CeFi, is the interest rate typically stays the same over time. You don’t have to worry about the interest rate skyrocketing overnight and you suddenly having large interest payments. That, and the apps or services will have automated messaging available for you in case something goes wrong with the market, and you are at risk of being liquidated. With DeFi based loans, you must be on top of your game in order to properly monitor your loan.
Be sure to check out BlockFi, Crypto.com, and Binance for reputable CeFi lending services.
Borrowing Through Decentralized Finance (DeFi)
If you borrow through a DeFi service, then you’re borrowing by interacting with a smart contract. That means that you’re placing your money in the hands of the code. Unless you know how to read the code, then you’re taking it on faith that the code works the way that the administrators say it will.
Because the lending contract is autonomous in many ways, the interest rates that govern the loans typically will fluctuate. There is often no such thing as a fixed interest rate in the DeFi world, simply because of how these contracts are designed. There is the additional risk of market volatility beyond what you might see on a CeFi service. In the event of a flash crash, you may lose your collateral or be stuck with a couple large interest rates, which drastically increase your loan principal.
That being said, it is extremely cool that you can lock up your assets, and get money in the form of DAI, USDT, or USDC. All this, without asking anyone’s permission, at the click of a button.
How to Use the Debt You’ve Taken Out
As I mentioned earlier, the best case scenario for taking on debt is making more money than what you took out. When you go to pay off your debt later, the difference between what you made, and what you took out is all profit.
Lets just say that you borrow $10k USDT at a 5% interest rate. Then you find a lending service that lets you earn 10% interest by lending USDT. You can borrow $10k for 5%, lend it back out at 10%, and profit 5%. For every dollar you earn, you owe $.50 of it in interest, and get to keep the other $.50. This is a simple example of how debt can end up making you money, instead of costing you money. This example is actually fairly common with the crypto world as well. It is not difficult to find 10% or higher interest rates when lending stablecoins like USDT, DAI, USDC, and others.
What is Liquidation?
Being liquidated is the worst case scenario when taking on debt. Liquidation occurs when the value of your collateral falls below some arbitrary level of tolerance set by the lender. The typical standard liquidation level is if the value of your collateral is only worth 15% more than what you owe. The other way of thinking about this, is if the amount you owe is worth 85% of the value of your collateral. This is the tipping point of danger for lenders, and at this point, your collateral would be seized, and sold on the market in order to pay off your debt. When this happens, you don’t owe money anymore, but you’ve also lost your collateral. Allow me to illustrate with an example.
I lock up $20k worth of Bitcoin to take out $10k worth of USDT.
The value of that Bitcoin can fall to $11,501 before my loan is liquidated. If the value of the collateral reaches $11,500, then my collateral is sold at the market rate, and my loan is paid off. I am left with zero debt, but also zero Bitcoin.
Should You Take on Debt?
Nothing in this article is financial advice. It is simply meant to educate you on what is possible, and how the mechanics of loans work within the world of crypto.
You should really only be experimenting with money that you can afford to lose. When in doubt, start small in order to gain an understanding of how the system works before putting any large amounts of money at risk. Make sure to only use services that have been thoroughly reviewed, and used by others. When in doubt, consult your financial advisor and get them to educate you on the risks and rewards of taking on more debt.
