Crypto-Backed Loans: Smart Strategies for US Borrowers

For a whole lot of people in the States, holding onto cryptocurrency is about more than just making an investment - it's also about having a potential source of ready cash. And, as it turns out, crypto-backed loans can be a pretty nifty way to tap into some funds without having to sell off your coins - a major benefit for those who've got faith in the long-term value of their holdings.

For those who don't want to part with their coins, crypto-backed loans make perfect sense. It lets you keep holding onto your crypto while getting your hands on some fiat or stablecoins to cover your immediate expenses - whether that's a down payment, a business expansion or just dealing with some unexpected bills.

At its heart, a crypto-backed loan works a lot like a traditional secured loan. You put up your cryptocurrency - often Bitcoin or Ethereum - as collateral to get a loan in a more stable asset like a stablecoin (USDC or USDT for instance), or even some good old fiat currency. This happens either through a centralised platform (CeFi) or a decentralised protocol (DeFi). In CeFi, a company holds onto your crypto and issues the loan. With DeFi lending, smart contracts do all the heavy lifting - they hold your collateral in a sort of escrow system and then release the funds as soon as all the necessary conditions are met. The amount you can borrow is usually a certain percentage of the value of your collateral - that's known as the Loan-to-Value (LTV) ratio and it can range anywhere from 30 to 70% depending on which platform you use and how volatile your collateral is.

One of the main reasons why US borrowers are drawn to crypto loans is the speed and ease of use. Unlike traditional bank loans, you usually don't need to go through a whole lot of credit checks, which makes them a lot more accessible to people with less-than-perfect credit scores. The approval process can be really fast, sometimes taking just a few minutes or a few hours. And, by borrowing against your crypto, you avoid triggering a taxable event that would happen if you sold your assets. That's a pretty big incentive - it lets you stick to your long-term investment strategy while still getting access to capital when you need it.

But while they're certainly appealing, crypto loans come with some pretty significant risks - especially given the fact that digital assets are inherently pretty volatile. One of the biggest risks is liquidation. If the value of your collateralized cryptocurrency drops a lot and your LTV ratio gets too high, the platform or smart contract will automatically sell some or all of your collateral to pay off the loan and get the LTV back under control. And that can happen in a heartbeat during a market downturn. Another thing to worry about is smart contract risk in DeFi. While they've been audited, smart contracts can still have vulnerabilities that get exploited, potentially leading to a loss of funds. Centralized platforms have a risk of their own - counterparty risk - where the platform itself could run into some financial difficulties or security breaches. And then there's the regulatory uncertainty in the States, which adds another layer of complexity to the whole thing. Rules around crypto lending are still evolving and could impact the terms of these services or even whether or not they're even allowed.

Key Considerations and Advice:

• Get a Grip on LTV and Liquidation Thresholds: Before you commit to borrowing, try to get a really solid understanding of what the initial LTV is, how the liquidation LTV works, and how much wiggle room you've got. Generally, it makes sense to go for a lower initial LTV to leave some buffer for price fluctuations. Stay on Top of Your Collateral: Crypto market can be pretty volatile so you need to keep a close eye on the price of the collateralized assets you've got pledged. Many platforms offer alerts but its also really helpful to proactively monitor things. Be prepared to top up your collateral or part repay your loan if prices take a dive and you're at risk of liquidation.
• Choose Your Platform Wisely: Look at both centralized and decentralized options. Centralized platforms are pretty easy to use but come with some counterparty risk. Decentralized protocols like Aave or Compound can be a lot more transparent but do require a bit more technical know-how and come with the risk of smart contract bugs. Check out their security history audit reports interest rates and fees before committing to anything.
• Don't Get Carried Away with Interest Rates and Fees: Compare interest rates across different platforms - they can be all over the place. Plus, rates are often dynamic especially in Decentralized Financial protocols. Don't forget to factor in any origination fees, repayment fees or gas fees that are involved.
• Tax Implications in the US: This is a big one. While borrowing itself is not taxable, if your collateral gets liquidated that's a taxable event. The sale of your crypto to cover your loan will count as a capital gain or loss. Get some advice from a tax pro who knows crypto to figure out your specific situation and how to properly report these transactions.
• Emergency Planning is Key: Work out what you'll do if your collateral value takes a hit. Do you have some extra cash set aside to top up your collateral? Or are you prepared for the possibility of liquidation? Never borrow more than you can afford to lose.
• Purpose of the Loan: Think carefully about why you need the loan. Are you borrowing to invest in something that might give you a higher return than your interest rate? Or are you buying something that's going to depreciate in value? Whether to borrow or not is a question of good financial common sense.