While the usual way to invest in cryptocurrency is simply buying and holding, there are often passive income opportunities that can boost your returns. One of the most popular is crypto lending. It allows you to earn excellent interest rates on your holdings, but there are risks involved. Here’s how to get started with crypto lending and what you need to know before investing your hard earned money.
Defining Crypto Lending
Crypto lending is when you lend your cryptocurrency funds to borrowers in exchange for interest payments. It’s available through crypto exchanges with lending programs and decentralized crypto lending protocols. These protocols are decentralized finance (DeFi) apps (platforms without a central authority managing them) where users can borrow or lend crypto.
It should be noted that crypto lending has multiple definitions. Crypto lending can also refer to using your cryptocurrency as collateral to get a cash loan. However, the more common definition, and the one that’s important to investors, is lending your cryptocurrency to earn interest on it.
How does Crypto Lending work?
Crypto lending platforms serve as the middleman between lenders and borrowers. Lenders deposit their cryptocurrency with the lending platform. Borrowers get cryptocurrency loans through the lending platform, which uses the cryptocurrency that lenders have deposited to fund these loans.
Borrowers repay loans with interest and lenders earn interest paid in cryptocurrency based on the amount they’ve deposited. The lending platform sets both the interest rates that borrowers pay and the rate that lenders receive. Rates vary depending on the platform and the cryptocurrency, and there may be fees involved for both parties.
Crypto lending works the same way whether it’s through a company or a decentralized lending protocol. The one major difference is that if you want to borrow or lend through a company, you need to register for an account first. Decentralized lending protocols typically don’t require registration; you can lend or borrow just by connecting your crypto wallet.
How did Crypto Lending start?
SALT Lending, which launched in 2016, was the first platform to offer crypto-backed loans. It was followed in 2017 and 2018 by the launch of several companies that allowed users to lend and earn interest on their cryptocurrency, including Lendingblock, Celsius Network, and CoinLoan.
Decentralized crypto lending protocols came a bit later. Unlike the aforementioned crypto lending companies, decentralized lending protocols are built using smart contracts and don’t require a central entity to manage them. MakerDAO, which launched in 2017, is one of the earliest examples. DeFi grew quite a bit in popularity in 2020 and 2021, leading to the launch of several new lending protocols, including Compound and Aave.
Types of Crypto Lending
There are several types of cryptocurrency loans available:
Collateralized loans
Collateralized loans are the most popular and require deposited cryptocurrency that is used as collateral for the loan. Most platforms require overcollateralization, which means that borrowers can access only up to a certain percentage of the deposited collateral (typically below a 90% loan-to-value). The lower the loan-to-value (LTV), the lower the interest rate, as well as a lower risk of being margin called.
Crypto line of credit
Instead of offering a traditional loan with a predetermined term length, some platforms offer a cryptocurrency line of credit. This is a type of collateralized loan that allows users to borrow up to a certain percentage of deposited collateral, but there are no set repayment terms, and users are only charged interest on funds withdrawn.
Uncollateralized loans
Uncollateralized loans are not as popular, but they function similarly to personal loans. Borrowers must fill out a loan application, pass identity verification, and complete a creditworthiness review to be approved. These loans have a higher risk of loss for lenders because there is no collateral to liquidate in the event of a loan default.
Flash loans
Flash loans are typically available on crypto exchanges and are instant loans that are borrowed and repaid in the same transaction. These are very high-risk loans that are typically used to take advantage of market arbitrage opportunities, such as buying cryptocurrency for a lower price in one market and instantly selling for a higher price in another, all within the same transaction.
Advantages and disadvantages of crypto loans
Crypto loans have been commonly used tools in the DeFi space for years. But despite their popularity, there are some disadvantages. Make sure to take a balanced look before you decide to experiment with lending or borrowing:
Advantages
1. Easily accessible capital. Crypto loans are given to anyone who can provide collateral or return the funds in a flash loan. This quality makes them easier to acquire than a loan from a traditional financial institution, and there’s no credit check needed.
2. Smart contracts manage loans. A smart contract automates the whole process, making lending and borrowing more efficient and scalable.
3. Simple to earn passive income with little work. HODLers can drop their crypto in a vault and begin earning APY without having to manage the loan themselves.
Disadvantages
1. High risk of liquidation depending on your collateral. Even with highly over-collateralized loans, crypto prices can drop suddenly and lead to liquidation.
2. Smart contracts can be vulnerable to attack. Badly written code and back-door exploits can lead to the loss of your loaned funds or collateral.
3. Borrowing and lending can increase the risk of your portfolio. While diversifying your portfolio is a good idea, doing so through loans will add extra risks.
Things to consider before getting a crypto loan
By using a trusted lending platform and stable assets as collateral, you’ll have the best chance of crypto loan success. But before you rush into lending or borrowing, consider the following tips too:
1. Understand the risks of handing over custody of your crypto coins. As soon as the coins leave your wallet, you’ll have to trust someone else (or a smart contract) to handle them. Projects can be the targets of hacks and scams, and, in some cases, your coins may not be immediately accessible to withdraw.
2. Think about market conditions before lending your crypto. Your coins may be locked up for a certain period, making it impossible to react to crypto market downturns. Lending or borrowing with a new platform can also be risky, and you may be better off waiting until it builds up more trust.
3. Read the loan terms and conditions. There’s a vast amount of choice available of where to take out loans. You should look for better interest rates and favorable terms and conditions.
Final Thoughts
Crypto lending platforms provide value to both the borrower and lender when done responsibly. HODLers now have another option to earn passive income, and investors can unlock the potential of their funds by using them as collateral. Blockchain technology has made it easier than ever to access and provide credit, making crypto loans a powerful tool for those who are interested. It is all up to us how we will maximize the technology and put it to good use.
