Crypto loans: What are they and how do they work?

Crypto loans: What are they and how do they work?

Wherever you have a monetary system you have the ability to borrow, right? Theoretically, yes. So it should be no surprise that a number of enterprising individuals have entered the crypto space by creating platforms that allow people to borrow money through a combination of cryptocurrency and peer-to-peer lending. The platforms allow you to borrow digital tokens the same way you would fiat.

You may have trouble wrapping your brain around this concept inasmuch as digital tokens are not tangible assets. But when you stop and think about it, fiat isn't all that much better. The world long ago left off backing fiat with gold, silver, and other precious metals. In most countries today, fiat is worth little more in real terms than the paper and coins that provide its substance.

The fact is that fiat derives its value through a combination of usefulness and user agreement. The same two principles provide the underlying value of cryptocurrency as well. So if you can loan fiat, there doesn't seem to be any reason you couldn't successfully loan cryptocurrencies.

What is a crypto loan?

So, what is a crypto loan exactly? It is a loan made with digital coins rather than fiat. Choices are limited at the current time, mainly just to Ethereum for now. You could borrow so much ETH and agree to repay the lender over time. You would incur loan fees and interest for the privilege of doing so.

According to Crypto News, the average rate among early adopters of cryptocurrency loans currently stands at roughly 5.7% for borrowers with high credit ratings.That compares to an average 9.5% offered by banks on fiat loans. Right from the start you can see the advantage here. Lower interest means a lower total cost of borrowing when all other things are equal.

Why a person would want tomorrow crypto is another question entirely. You go to a bank to arrange financing for a car, but we don't know any car dealers currently accepting crypto payments. You arrange a mortgage in order to buy a house. We have yet to see a homeowner sell a property for ETH rather than fiat.

Perhaps some people might want to borrow in order to invest in cryptocurrency as a security. They borrow because they do not really have the cash to fund their investments. This is probably not a good idea given the volatility of most cryptocurrencies, but we would venture to guess that some people are still doing it.

People borrow fiat in order to buy stocks and shares. That is not a wise idea either. Still, it is common practice in the investment world. So it stands to reason that some people who would borrow cryptocurrency would do so for investment purposes.

What is the role of peer-to-peer lending?

We cannot talk about crypto borrowing without also talking about peer-to-peer lending. The simple fact is that there is no such thing as a cryptocurrency bank making loans to people in need. So if there are no crypto banks, we need another source of coins. Herein lies the role of peer-to-peer lending.

Peer-to-peer lending, also known as P2P, is a form of lending in which multiple investors pool their resources through an online platform. Their combined resources are then lent out to customers at reasonable interest rates and with a minimum of fees and charges assessed.

You might have 100 investors with $100,000 each. Pool all of their resources together and you have $10 million to fund a P2P platform. The platform can then match available money with borrowers. The platform acts as a middleman of sorts, introducing lenders and borrowers. It also provides the tools necessary to work out and finalize a loan agreement.

Peer-to-peer lending in the cryptocurrency universe is no different than the same kind of lending in the fiat world. All underlying principles are the same. The only real difference is that one deals in fiat options like the U.S. dollar and the British pound while the other loans ETH or some other digital currency.

How does it work?

Borrowing from a P2P platform is pretty straightforward in practice. To begin with, the borrower sets the terms and conditions of the loan at the time of application. Try that with a high street bank and see how that goes. Borrowers being able to set the terms is one of the advantages of crypto borrowing.

Once a loan application is completed, the platform submits it to member investors. A single investor with enough resources to cover the entire deal can choose to accept it. But there is nothing preventing multiple borrowers from pooling their resources to cover a loan too big for any one of them to cover individually.

The borrower sends either digital tokens or ENS domains as collateral on a loan. Just like a standard fiat loan, the borrower stands to risk losing the collateral if he or she defaults. Collateral can be legally possessed by lenders to cover losses in such situations.

The last step is to actually transfer the coin from the P2P platform to the borrower's digital wallet. At that point the deal is done. It is up to the borrower to make payments as agreed to in the loan contract. Those payments must be made on time and with whatever tokens were agreed on by the two parties.

Is crypto lending a wise idea?

If the idea of borrowing cryptocurrency intrigues you, understand that there are two sides to every digital coin. You may think is a great idea to borrow ETH so that you can get in on cryptocurrency as an investment. And it might very well be. Borrowing could open the door to investment opportunities you would not have otherwise had access to. But the other side of the coin is the lender's side.

Crypto lending has received plenty of criticism in the short time it has been available. Cryptocurrency's historical volatility is at the top of the list of criticisms leveled by those who warn investors to stay away from crypto lending. It is a legitimate concern when looked at strictly from a dollars and cents point of view.

If you follow cryptocurrency on a daily basis, you are aware that we are in the midst of what is being called 'crypto winter'. Prices are down significantly since the start of Q4 2018, and there are no imminent signs of a large-scale comeback. Crypto winter is not a good scenario for lenders.

Volatility creates a big problem where store of value is concerned. To put it as simply as we can, let's say you have $1,000 in ETH you have made available through a P2P lending platform. You accept a loan deal, send your coin, and then sit back and wait for payments and interest to come in.

Imagine you set your interest rate at 5%. How much money would you make if the value of ETH dropped by 10% during the loan term? If that loan term were no more than a year, compounded interest would not apply. You would wind up losing money on both the value of your coin and the value of the interest charged on the loan.

Is there always risk in crypto?

Critics of crypto lending cite other problems with it as well. But at the end of the day, almost all of the criticisms are not unique to crypto lending. They also apply to lending fiat, investing in stock markets, dabbling in commodities, etc. They are all risks that are part and parcel with the financial sector.

In reality there is always risk when dealing in cryptocurrency, even if you do nothing more than purchase bitcoins so you can play slots online. Your $500 investment in bitcoins could be worth only $400 when you wake up in the morning. That is the reality of crypto.

By the same token, your $500 could be worth $1,000 next month. That's one of the things that makes crypto investing so attractive. The fact that volatility swings both ways gives investors an equal chance of being both broke and filthy rich.

The prospect of building wealth is likely that which motivates people with significant crypto assets to consider peer-to-peer lending. For the investor with a moderate aversion to risk, peer to peer lending is not a bad way to earn a little extra on your holdings.

Taking volatility out of the equation makes peer-to-peer lending look quite attractive. Peer-to-peer lending invites people who don't want to do business with traditional banks. And when crypto is part of the equation, it invites borrowers who cannot do business with traditional banks.

Now you know what a cryptocurrency loan is and how it works. As to whether or not you should borrow crypto, that is not for us to say. The best advice we can give is that you use a combination of caution and common sense before you borrow any kind of money. Borrowing is a tremendous responsibility that should never be taken lightly. Be sure you know exactly what you are getting into before you sign on the dotted line.

Byline: This article was published by Henry.
About: I'm a bitcoin advocate and admin of Coinbet.com.