NerdWallet: Should you borrow against crypto? Here are the risks
This article is reprinted by permission from NerdWallet.
Like a house, car or other investment, your cryptocurrency can serve as collateral for crypto loans, which are loans that can have low interest rates, same-day funding and no credit check.
The downside? If your crypto’s value falls, you may need to pledge more crypto.
“That is going to be the main disadvantage of crypto,” says Travis Gatzemeier, a certified financial planner and founder of Kinetix Financial Planning near Dallas. “It’s not a normal, stable asset that you’re using to borrow.”
Despite the risks, cryptocurrency — and borrowing against it — have become popular topics on public forums like Reddit and YouTube. But is a crypto loan right for you?
What is cryptocurrency?
Cryptocurrency entered the financial dialogue in 2008, with an anonymous programmer’s white paper on the concept of bitcoin.
Bitcoin is a cryptocurrency, or a digital form of money. It might seem complex — and depending on how you use it, it can be — but it’s essentially digital tokens as opposed to physical money. It can be exchanged for goods and services on the blockchain, which is a digital ledger that keeps track of every bitcoin transaction.
“The idea is meant to be pretty simple,” says Ariel Zetlin-Jones, associate professor of economics at Carnegie Mellon University in Pittsburgh.
Watch: Are crypto and meme stocks a fad?
Throughout history, we have accepted physical tokens in exchange for goods and services, believing we can then trade those tokens as money for other goods and services in the future. Blockchain and bitcoin facilitate the same kind of transactions but without the need for physical tokens, says Zetlin-Jones.
What is a crypto loan?
A crypto loan is a type of secured loan, similar to an auto loan, in which you pledge an asset to secure financing.
In this case, cryptocurrency is the asset offered to a lender in exchange for cash that you’ll pay back in installments. If you fail to repay the loan, the lender will liquidate or cash out the cryptocurrency.
Crypto lenders like BlockFi, Celsius and Unchained Capital have relatively low annual percentage rates and one- to three-year loan terms, but high minimum loan amounts.
For example, BlockFi’s crypto loans start at 4.5% APR on one-year loans, but the minimum loan amount is $10,000.
Why borrow against crypto?
A crypto loan may make sense if someone holds a substantial amount of crypto and wants to liquidate it without having to sell and possibly pay taxes on it, says Gatzemeier.
Those funds could then be used for a purchase or to invest in a business, similar to borrowing with a personal loan.
Additionally, borrowers could see lower interest rates with a crypto-secured loan. And unlike personal loans, there’s no credit check.
Also see: Should I buy a bitcoin ETF? Here’s what some pros say you should consider
The problem of crypto loans
From April 2021 to October 2021, bitcoin’s
price fluctuated between about $30,000 and $64,000.
The unsteady value of crypto can lead to a margin call, where the borrower must put up more crypto to maintain the value of the initial pledge.
If the value of your pledged crypto declines below a threshold set by the lender, then you have a limited period of time to pledge additional crypto.
In crypto-speak, the ratio of the loan amount to the value of your collateral is called loan-to-value or LTV. For example, crypto lender BlockFi’s maximum LTV is 70%. At that threshold, borrowers have 72 hours to increase the crypto.
In addition to unstable pricing, crypto loans are also not federally insured, says Gatzemeier. If you lose your funds in a security breach, for example, compensation isn’t guaranteed.
Read: Coinbase ditches crypto lending program after receiving SEC lawsuit threat
Alternatives to borrowing against your crypto
If you have equity in your home: With a home equity line of credit, you can potentially borrow up to 85% of your home’s value. Be careful, though, as you can lose your home if you don’t repay.
If you’re looking for a lower interest rate: A 0%-interest credit card can offer free financing for 14 to 18 months. However, note that after the introductory period, you could pay a high interest rate on unpaid balances.
If you have bad credit: Credit union loans typically have flexible rates and terms. They also consider your history as a member, which means they may have softer requirements.
If you need a small loan: A small personal loan — below $2,000 — is also a viable option. However, rates may be high depending on your credit profile and income.
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Chanell Alexander writes for NerdWallet. Email: firstname.lastname@example.org.