A Guide to Collateralized Loans in DeFi

Hodling is the favorite sport of long-term crypto investors. However, keeping your assets in a crypto wallet for years can have negative consequences. Firstly, unless their value increases, you do not accrue any profits. Secondly, it limits market liquidity and, therefore, hinders its growth. Fortunately, you can help solve both problems with collateralized loans.

This short guide to crypto lending discusses how collateralized loans work in decentralized finance. Read on to discover how to use this DeFi tool in your favor!

What Are Collateralized Crypto Loans?

As with most types of loans, collateralized crypto loans require a borrower and a lender. The borrower provides cryptocurrency like Bitcoin or Ethereum as collateral in exchange for fiat. On the other hand, the lender holds the collateralized crypto until the borrower repays the loan. If that doesn’t happen, the lender obtains full possession of the securities.

These decentralized finance (DeFi) operations occur on a lending platform or a lending pool. This service connects borrowers and lenders. Generally, it establishes a secure environment with specific loan interest rates. Also, it holds the collateral and releases it only after the borrower has paid back the amount in full. Conversely, it issues it to the lender if the borrower fails to repay the loan.

Some DeFi lending platforms allow users to use fiat currencies as collateral to obtain crypto assets. Nevertheless, all crypto lending platforms come in two forms:

Automated lending services

These platforms give investors dividends when depositing assets in their crypto wallets.

Manual lending platforms

These services ask investors to stake a specific amount of cryptocurrency to generate interest manually.

Some popular platforms offering collateralized loans include Aave, Uniswap, Compound, MakerDAO, and YouHodler.

Use Cases of Collateralized Loans in DeFi

The crypto lending market offers several use cases, which explains its growing popularity. For instance, investors can use it for:

Non-Taxable Liquidity

Those who like to “hodl” their crypto assets can profit without selling them. For instance, they can use their holdings as collateral to obtain loans in fiat currency and avoid taxes on gains.

Arbitrage Trading

Some crypto lending platforms provide arbitrage trading services. Simply put, an investor can borrow an asset from one platform and lend the asset to another.

Margin Trading

Investors can use crypto-collateralized loans to buy more collateral. They can offer even higher securities to access more significant funds.

Flash Loans

Users can borrow crypto to execute an application and pay back the loan almost instantly when the transaction ends.

Benefits of Collateralized Loans in Crypto

Collateralized crypto loans have unique features that enable them to provide investors with highly attractive benefits, such as:

Low-interest rates

Most platforms offer crypto loans with interest rates as low as 10%, which is relatively inexpensive for most borrowers. In addition, those looking for an alternative to personal loans from banks can opt for a collateralized loan in crypto.

Asset value dictates the loan amount.

Most crypto lending services allow borrowers to access loans as high as 90% of their portfolio. However, this depends on the asset’s value they want to loan.

A versatile offer of loan currencies

Unlike traditional loans, DeFi lending provides borrowers with countless currencies of choice. They can loan almost any asset they need instead of just USD, as most banking services offer.

No credit check

Most crypto lending platforms do not run extensive checks on their customers. This means borrowers can access loans much quicker and with less hassle than fiat loans from banks. Also, individuals with poor credit or no credit history do not need significant collateral to get a loan.

Fast access to funds

Most lending pools have enough assets to cover loan requests with substantial collateral. This way, borrowers can get their loans in just a few hours.

A passive income opportunity

DeFi lending platforms enable users to lend their digital assets to borrowers. All they have to do is pour crypto into the lending pools to earn interest. While the profit is not overwhelming, it is still a decent form of passive income. For instance, some of these services offer an APY as high as 10% in return for providing liquidity.

Risks of Collateralized Crypto Loans

As good as collateralized loans in DeFi may look, they are not perfect. On the contrary, crypto lending with collateral comes with several risks, such as:

Margin calls

The crypto borrower’s worst fear is the value of their collateral dropping below a specific level. At that point, the lender automatically requires them to increase their holdings. Otherwise, the loan would become null, and the borrower could lose the collateral. Furthermore, the lender may sell the borrower’s collateral to cut the loan-to-value ratio. Margin calls are most likely to happen in periods of high volatility.

Locked funds

Most borrowers offer the crypto funds they are comfortable with locking for a specific period as collateral. However, they cannot access these assets before they pay back the loan. This could become problematic if they wish to cash in a hurry or require more funds for other applications.

Varying repayment terms

Depending on the lending platform, borrowers may have limited time to repay their loans. This means that accessing substantial funds might be impossible for most investors. Therefore, most people seek to borrow small funds over short periods to avoid losing collateral.

No Insurance

Most DeFi lending services do not have insurance. If they default or fail, borrowers lose their collateral, and lenders lose their funds. Generally, most traditional banks have insurance, and their clients can recover their assets.

Slow interest withdrawals

Crypto lending is appealing to those looking to earn passive income. Unfortunately, most lending platforms take several days to release funds following a withdrawal request. This delay is inconvenient to those needing new funds quickly. However, it could be even more damaging if the value of the assets drops in this period. In this unfortunate case, investors cannot trade their holdings at their price when they request a withdrawal.

How to Pick a Cryptocurrency Lending Platform?

If this is your first time using a DeFi lending platform, you should consider several factors, such as:

• The platform’s history, track record, and community trust
• The interest rate for the specific asset you want to borrow
• The fees and withdrawal times
• The minimum deposit requirements
• The lending duration

Finally, you should check the collateral you need to provide and compare it with other platforms. Also, remember that you can use more than one lending platform. So, don’t put all your assets in one basket.

Conclusion – A Guide to Collateralized Loans in DeFi

Crypto liquidations occur in seconds, which is why cryptocurrencies make for the perfect collateral. Crypto loans represent a quick and inexpensive way of accessing new funds without a credit check. Also, they enable investors to capitalize on their holdings without selling them.