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Undercollateralized vs. Collateralized Loans in DeFi

The debate on undercollateralized vs. collateralized loans continues as investors look for the best ways to make money in cryptocurrency.

Decentralized Finance (DeFi) has taken the crypto industry by storm in 2020. Since then, the sector has spurred numerous lending tools that blew the doors wide open to cryptocurrencies for everyone. Suddenly, newbie and expert investors could access crypto funds with minimum investment.

Today, loans in DeFi are accessible to anyone willing to borrow or lend. They only need to decide whether they opt for a collateralized or undercollateralized loan. If you face the same dilemma, read on to find out which crypto lending solution is better for you.

What Are Collateralized Crypto Loans?

A collateralized crypto loan is a tool that enables investors to access new funds by providing collateral. Generally, you can use DeFi lending platforms or lending pools to borrow crypto or fiat. However, you will have to lock assets equal to or more valuable than the loan’s value as collateral. Generally, the borrowing party must provide at least 1.5–3x of the loan as collateral to access the credit.

For instance, you can borrow USDC, PAX, or even USD on DeFi platforms like Celsius. In return, you have to provide security in various cryptocurrencies, including Bitcoin and Ethereum. This collateral includes an interest rate that goes to the lender. When you repay your loan, the platform gives you back the assets. However, if you fail to pay back what you owe, the lender will obtain the securities.

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 manually stake a specific amount of cryptocurrency to generate interest.

Some of the most popular platforms offering collateralized loans include Aave, Uniswap, Compound, MakerDAO, Celsius, YouHodler, and BlockFi.

Some of these platforms allow users to lend their digital assets to borrowers. For instance, you can pour crypto into the lending pools to earn interest. While the profit is not overwhelming, it is still a decent form of passive income. These services offer an annual percentage yield (APY) as high as 10% in some cases. You can read more about collateralized loans here.

What Are Undercollateralized Crypto Loans?

Collateralized crypto loans are straightforward. You provide collateral of at least the same value as the loan. Then, as long as you pay it back, you can retrieve your assets. When it comes to undercollateralized loans, this process becomes more complex.

An undercollateralized loan enables borrowers to access crypto or fiat assets by providing collateral smaller than the loan’s value. In some cases, you may not have to provide securities at all. This is possible through credit delegation.

Here’s a hypothetical example of how that works!

Let’s say that Bob deposits $50,000 in a DeFi lending platform that provides undercollateralized loans. Next, Alice needs to borrow the same amount. However, she has very few or no assets to offer as collateral. So, how can she access the credit?

Well, Bob trusts and maybe even knows Alice. So, he delegates the credit to her. Now, Alice owns assets to the DeFi platform. And, whenever she makes payments to it, Bob gets his money back with additional interest.

This is just a simple example of how one kind of undercollateralized lending can work. Several types of undercollateralized loans exist in DeFi, such as:

  • Flash Loans
  • Third-party Risk Assessment
  • Crypto Native Credit Scores
  • Off-chain Credit Integration
  • Personal Network Bootstrap
  • Real-world Asset Loans
  • NFTs as Collateral
  • Digital Asset Loans

You can read more about undercollateralized loans here.

An undercollateralized loan in crypto is a fantastic chance for investors to access substantial credit without collateral.

Some of the DeFi protocols that support third-party risk assessment include Maple, Dharma, Truefi, Goldfinch, and Bloom. And some of the projects working in this direction include Ledgerscore, Wing, and Zoracles.

Benefits of Collateralized Crypto Loans

If you have the necessary assets, you can quickly apply for a crypto loan and enjoy several advantages, such as:

Low-interest rates

Generally, a DeFi lending platform will include at least a 10% interest rate with the loan. This amount is relatively inexpensive for most borrowers. Also, it provides a suitable alternative to traditional loans from banks.

The asset value dictates the loan amount

Depending on the asset you want to borrow, you can access loans as high as 90% of your portfolio.

A versatile offer of loan currencies

DeFi lending platforms and pools have developed to include several crypto assets and even fiat currencies. Contrary to traditional loans with banking institutions, in DeFi, you have a wide variety of choices.

No credit check

If you have ever applied for a loan with a bank, you are probably familiar with the slow bureaucratic process. Generally, you need a good credit check and reliable collateral. On the other hand, crypto lending is accessible even to those with poor credit or no credit history.

Fast access to funds

Most lending pools provide borrowers with the requested loans in only a few hours. This means that you could access the funds you need for a project within the same day you request them.

A passive income opportunity

Lending other investors could be a decent way of earning passive income. Several DeFi platforms allow users to earn interest for pumping their assets into liquidity pools. This way, you can sit back and let your money work for you rather than the other way around.

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 problem with providing crypto assets as collateral is that their value can drop at any time. The crypto market is famous for its high volatility. So, when your security’s value dips, the lender automatically requires you to increase the collateral. Furthermore, the lending platform may even sell the borrower’s collateral to cut the loan-to-value ratio.

Locked funds

Another issue with collateralized loans is that you have to lock the assets while the loan is active. For example, as a borrower, you do not receive your collateral until you repay the loan. Conversely, as a lender, you have to wait for the borrower to pay back. Above all, this could become problematic if you wish to cash in a hurry.

Varying repayment terms

Due to high market volatility, the repayment time is generally short on most lending platforms. This means that you have to pay back what you owe quickly. Otherwise, you risk losing money to margin calls. Also, this affects the amount you can borrow as large loans are usually hard to repay and, therefore, scarce.

No Insurance

Contrary to traditional loans through banks, collateralized lending in DeFi does not have insurance. This means that if the lending platform defaults or fails, you lose your funds, whether they are loans or collateral. And, with no insurance, you have no one to help you retrieve them.

Slow interest withdrawals

As a lender, you may find that retrieving your passive income from interest rates is sluggish and difficult. Most lending platforms have an interest in keeping the lending pools as rich as possible. Therefore, they make withdrawals slow, which could prove frustrating for many.

Benefits of Undercollateralized Loans

Decentralized finance (DeFi) is steadily replacing many traditional financial tools. Furthermore, it empowers unbanked people to access financial services and improve their situation. In this regard, undercollateralized crypto loans enable those with limited assets to fund otherwise inaccessible ventures.

When you apply for an undercollateralized crypto loan, you gain several benefits, including:

  • Not needing the approval of bankers or brokers
  • The security of immutable blockchain technology
  • Global availability
  • Access to funds without restricting eligibility standards
  • Free from the control of centralized authorities
  • Full asset management
  • Peer-to-Peer (P2P) loans

Additionally, most DeFi lending platforms include low-interest rates with undercollateralized loans. The possibility to loan funds with low or zero collateral should attract more people to DeFi. In return, this should create a spiral effect where the ecosystem expands to create even more financial tools. And in time, decentralized finance may have more users and beneficiaries than the centralized system.

Risks of Undercollateralized Loans

Unfortunately, undercollateralized crypto loans are not flawless and risk-free. They come with similar disadvantages as their collateralized counterparts. Also, they may have other downsides, such as:

Asset Liquidity

Contrary to collateralized crypto loans, those that do not require security are rarely versatile. For instance, you may find that most lenders and borrowers prefer a handful of lending pools. Generally, these pools represent some of the most popular crypto-assets. So, if you need to borrow a specific asset, you may not find the necessary funds. Alternatively, if you wish to lend a rare asset, you may find that nobody wants to borrow it.

Instant Repayment

This risk is valid for flash loans, which require the borrower to repay before the lending transaction ends. As a result, they become the least suitable form of borrowing for personal purposes.

Popularity Dip

Besides market volatility, an asset’s value can be the victim of negative popularity. Therefore, the value of a loan may drop drastically and cause the lender to lose a fortune. Some believe that this is a risk of lending platforms using NFTs as collateral.

Conclusion – Collateralized vs. Undercollateralized Loans in DeFi

Loans have been around ever since humans placed value on things and transformed them into assets. Nowadays, lending transcends from the physical world into the virtual space through crypto loans in decentralized finance. This technological and cultural breakthrough comes with almost countless benefits, as we saw above. However, it also incorporates risks for both expert and newbie investors.

Whether you opt for a collateralized or an undercollateralized crypto loan, you will have advantages and downsides. You can use both tools to access new funds, subsidize a project, or earn passive income. On the other hand, you can also see your portfolio’s value decrease severely.

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Choosing one or the other depends only on how much collateral you are willing to provide. The same goes if you wish to provide any security at all. Nevertheless, you will have to do your own research and choose carefully before lending or loaning in DeFi.

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