Crypto lending: How it works and different types

Lending and borrowing have long been cornerstones of the financial world, enabling individuals and businesses to access capital. With the dawn of the digital assets age, these concepts have carried over into the world of crypto. 

Similar to their traditional counterparts, crypto mortgages offer a modern twist, allowing borrowers to secure loans without selling their cryptocurrency. Using crypto as collateral, borrowers can acquire assets like real estate while retaining their digital investments – and any potential future gains.

In this guide, we'll explore crypto lending, its advantages, disadvantages, and practical use cases, such as crypto mortgages and collateralized loans.

Understanding crypto lending

In both traditional finance and the emerging field of cryptocurrency, lending operates on similar principles, though the mechanisms differ.

In the traditional financial system, individuals deposit money with banks, which then loan it to borrowers for purposes like starting or expanding businesses, buying homes, or making large purchases, charging interest while paying depositors a share of these gains.

Crypto lending operates similarly to traditional lending but within the digital asset ecosystem. Most crypto loans are facilitated through dedicated lending or crypto finance platforms, where people deposit their coins much like they would with a bank, and the platform lends out the funds. Peer-to-peer (P2P) crypto loans are also possible, allowing individuals to lend and borrow directly from one another without the need for a centralized intermediary.

In both cases, a crypto loan involves one person lending cryptocurrency to another in exchange for interest, compensating the lender for their time and risk.

Why take out a crypto loan?

There are several reasons a borrower might choose a crypto loan over a traditional one. Here are three of the most common benefits:

No credit checks

Most crypto loans don't require credit checks, making them more accessible than traditional loans, which often require a strong credit history for approval. This allows individuals with poor or no credit history to qualify for loans, broadening access to financing.

Faster

Crypto loans typically have quick approval processes, often finalized within the same day of application. This speed is beneficial for borrowers needing immediate access to funds, unlike traditional loans, which can take several days or weeks to process.

Potentially lower interest rates

Many crypto loans offer lower interest rates than traditional unsecured loans, making them a more cost-effective option for borrowers. Rates can be as low as 5%, or even 0% in some exceptional cases, compared to traditional loan rates, which may be significantly higher, especially for those with less-than-perfect credit. However, it's important to note that crypto lending rates can vary widely, sometimes reaching up to 23%, similar to credit card rates.

Types of crypto loans

There are different types of loans for cryptocurrency, and understanding how they vary is essential for making an informed borrowing decision.

Collateralized loans

Collateralized loans are the most common type of crypto financing available today. With these loans, borrowers stake their crypto holdings as collateral. If they fail to repay the loan, the lender receives their crypto as compensation. Collateralized loans are popular because they allow individuals to retain ownership of their crypto as it appreciates in value while still accessing liquidity for everyday purchases and transactions.

CeFi loans

CeFi, or centralized finance, loans are offered by centralized platforms such as Salt. These loans are typically more convenient and user-friendly than DeFi alternatives, but they usually require know-your-client (KYC) verification, which makes them less private. CeFi loans are suitable for borrowers who prioritize ease of use and don’t mind undergoing identity verification.

DeFi loans

DeFi, or decentralized finance, loans enable individuals to use decentralized protocols and smart contracts to lend and borrow money without a centralized authority. DeFi loans offer increased privacy and faster transaction times compared to CeFi loans, as they don’t require intermediaries or KYC verification. They are ideal for those who value privacy and are comfortable interacting with decentralized applications.

How are crypto loans taxed?

The taxes you owe can vary greatly depending on your specific situation. In the United States, borrowers of crypto loans generally do not pay tax on the loan itself. Any interest paid may be tax-deductible if the loan is used for business or investment purposes. However, a key tax implication for borrowers is that repaying a loan with appreciated cryptocurrency could trigger capital gains tax on the increased value of those coins. Additionally, selling borrowed crypto after it has appreciated can result in a taxable capital gain.

Conversely, lenders must pay tax on the interest payments they receive from the loan as ordinary income. Additionally, if they liquidate any collateral due to an unpaid loan, they may also need to pay taxes on that amount.

Six of the top crypto lending platforms

Interested in taking out a crypto loan? If so, several platforms can help you get started. Here are six to consider: 

• Arch: A regulated platform operating in 32 U.S. states, Arch offers competitive crypto loans, including options for direct USD deposits to U.S. bank accounts, providing a secure and straightforward loan process for borrowers.
• Salt: Salt offers crypto-backed loans that allow users to leverage their cryptocurrency as collateral without needing to sell it, providing quick access to liquidity with no credit checks, competitive rates, and adaptable terms.
• Aave: Aave allows users to borrow and lend a wide variety of cryptocurrencies with options like flash loans, offering a high degree of transparency and control.
• Binance: One of the largest cryptocurrency exchanges globally, Binance offers a wide range of crypto products, including loans. 
• Crypto.com: Crypto.com is a popular platform that offers a variety of crypto-related services, including a crypto debit card and competitively low interest rates ranging from 5% to 6.5%. 
• Compound Finance: Compound Finance offers an automated market where interest rates adjust based on supply and demand, providing users with flexibility and transparency.

Five common crypto lending risks

Like any type of loan, crypto lending comes with its fine print. Before lending or borrowing crypto, it's crucial to understand the potential risks involved:

Lack of legal clarity

Crypto loans operate in a regulatory gray area. Regulations around lending and borrowing cryptocurrencies are still evolving, which can lead to confusion and potential legal issues. Without clear legal frameworks, both lenders and borrowers may face unexpected legal challenges or changes in regulations that could impact their agreements. It’s essential to stay informed about the legal environment in your jurisdiction and seek professional legal advice if necessary.

Volatility

Cryptocurrencies are known for their high volatility, with prices experiencing significant swings in short periods. This fluctuation can put borrowers in a difficult financial situation if their collateral loses substantial value during the loan period, potentially leading to a margin call or liquidation. Borrowers should carefully consider the risks and avoid over-leveraging by maintaining a diversified portfolio to mitigate potential losses.

Margin calls

One of the consequences of cryptocurrency volatility is the risk of margin calls. A margin call occurs when a lender requires the borrower to provide additional collateral, repay part of the loan, or risk immediate default if the value of the collateral drops significantly. This situation can be stressful for borrowers, especially during market downturns. To mitigate this risk, borrowers should monitor their collateral's value closely and be prepared to act quickly if market conditions change.

Insolvency risk

The crypto lending market is relatively new and includes many players, often newer startups. While these startups drive innovation, smaller, less established companies risk running out of cash and becoming insolvent, potentially leaving lenders without their funds and borrowers without their collateral. To minimize this risk, conduct thorough due diligence on lending platforms, including evaluating their financial stability, security measures, and user reviews.

Rehypothecation risk

Rehypothecation occurs when a lending platform uses collateral provided by borrowers for its own purposes, such as further lending or investing. While this can allow platforms to offer more favorable terms, it also introduces significant risk for borrowers. If a platform rehypothecates collateral and then faces financial difficulties, borrowers may lose their collateral altogether. This can be especially problematic in the event of a platform's insolvency, as collateral may not be recoverable. Always verify whether a platform engages in rehypothecation and carefully consider these risks before committing assets.

Categorizing lending transactions with CoinTracker

Crypto lending is becoming increasingly popular, providing borrowers with a cost-effective way to access capital while allowing lenders to earn interest on their holdings. However, these benefits come with additional paperwork and potential tax implications.

CoinTracker can help. As a trusted crypto tax application for millions of users, CoinTracker assists in categorizing lending transactions on a modern and secure platform. By connecting your crypto wallets and exchanges, CoinTracker can generate optimized tax reports in minutes.

Have your crypto taxes done right with CoinTracker. Start for free and discover why more than 2 million traders trust CoinTracker for their digital assets tax needs.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.