Understanding Bitcoin Loans and How They Work

Bitcoin loans are growing in popularity, providing a way for holders to access liquidity while still retaining ownership of their underlying Bitcoin.

Bitcoin loans function quite differently from traditional loans though, and understanding how they work can offer insights to holders looking to leverage their bitcoin without selling them.

What Are Bitcoin Loans?

Bitcoin loans are a type of financial arrangement where individuals use their bitcoin holdings as collateral to secure a loan. These loans allow borrowers to receive fiat currency or stablecoins without selling their bitcoin. Essentially, rather than selling their bitcoin for cash, users can borrow against it, giving them access to liquidity while keeping their bitcoin exposure.

The key difference between traditional loans and bitcoin-backed loans lies in the collateral and the borrowing process. Traditional loans are typically based on creditworthiness and require credit checks, employment verification, and a history of financial transactions.

On the other hand, bitcoin loans are based solely on the value of the bitcoin collateral, bypassing the need for credit checks. Bitcoin is held by the lender (or a third-party custodian) for the duration of the loan. If the borrower fails to repay the loan or if the value of bitcoin falls significantly, the lender has the right to liquidate the bitcoin to cover the loan.

How Bitcoin Loans Work

Source: Koinly

Types of Bitcoin Loans

Bitcoin loans come in various forms, depending on the custody model, the lending platform, and whether or not they require collateral.

Custodial loans involve the borrower transferring their bitcoin to the lender or a third-party custodian, who holds the collateral until the loan is repaid. This model is more common and is offered by many centralized platforms.

Non-custodial loans, on the other hand, utilize smart contracts to lock up bitcoin without requiring the borrower to hand over their private keys. These loans are more common in decentralized finance (DeFi) platforms.

Most bitcoin loans are secured, meaning they require collateral (in the form of bitcoin) to back the loan. Secured loans are generally safer for the lender because they can liquidate the collateral if the borrower defaults or if the loan’s terms are violated.

Unsecured bitcoin loans, which don’t require collateral, are rare and come with higher interest rates due to the increased risk for the lender. 

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The difference between CeFi and DeFi Lending

Source: Medium

How Bitcoin Loans Work: The Loan Process

The process of applying for a bitcoin loan is straightforward but requires an understanding of the mechanics involved, especially the role of collateral and the terms associated with the loan.

To apply for a bitcoin loan, a borrower first needs to select a lending platform. After signing up, the borrower deposits bitcoin into the platform, which is held as collateral. The platform then assesses the value of the collateral and offers a loan amount based on the loan-to-value (LTV) ratio.

The LTV ratio determines how much you can borrow relative to the value of your bitcoin. For example, with a 50% LTV, if you deposit $10,000 worth of bitcoin, you can borrow up to $5,000. Once the loan is issued, the borrower receives cash or stablecoins, and the loan must be repaid over time with interest.

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LTV Ratio Equation

Source: Nexo

The LTV ratio is critical in determining the loan’s terms. If the value of bitcoin falls, the LTV ratio increases, and the borrower may face margin calls, requiring them to either repay part of the loan or add more bitcoin as collateral. Failure to meet these requirements could result in liquidation of the collateral.

Pros and Cons of Bitcoin Loans

Advantages of Bitcoin Loans

• Lower Interest Rates: Due to the collateralized nature of bitcoin loans, interest rates can be lower compared to traditional unsecured loans.

Note: For clarity, unsecured loans, like personal loans and credit cards, often carry higher interest rates due to the lack of collateral backing. In contrast, Bitcoin loans, which are collateralized with bitcoin, can offer lower rates since the collateral reduces the lender's risk. This makes Bitcoin-backed loans distinct from other types, such IRA loans, which may also offer competitive rates but are secured by property or retirement assets, respectively.

• No Credit Checks: Since bitcoin serves as collateral, there are no credit checks involved, making these loans accessible to a wider audience.
• Access to Liquidity Without Selling Bitcoin: Borrowers can access cash or stablecoins without having to sell their bitcoin, preserving their long-term investment potential.

Risks of Bitcoin Loans

• Price Volatility: Bitcoin’s price is highly volatile, and a sharp decline in value could trigger margin calls or liquidation of the collateral.
• Potential Liquidation: If the borrower cannot meet margin calls or the price of bitcoin falls too far, the collateral may be liquidated, resulting in loss of bitcoin.
• Platform security concerns: Centralized platforms hold custody of your bitcoin, so there is always a risk of hacks or security breaches, making the platform's reputation and security critical considerations.

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Popular Bitcoin Lending Platforms

Several platforms have emerged to facilitate bitcoin loans, offering different features and benefits depending on the borrower’s needs.

Centralized platforms like Unchained and Ledn offer a more traditional experience with dedicated customer support, lower learning curves, and often more stable interest rates. DeFi platforms like Aave or Compound operate through smart contracts, removing intermediaries and giving users direct control over their assets.

When choosing a lending platform, borrowers should consider several key factors:

• Security: Ensure that the platform has robust security measures and a history of safe operations.
• Interest Rates: Compare rates between platforms to find the most favorable terms.
• Fees: Look for any hidden fees, such as withdrawal fees or early repayment penalties.
• Platform Reputation: Research user reviews and platform track records to ensure reliability.

In conclusion, Bitcoin loans provide a unique way for bitcoin holders to access liquidity without selling their assets. While they offer significant advantages, including potentially lower interest rates, tax benefits, and no credit checks, they also come with risks tied to bitcoin’s volatility and platform security.

Understanding how bitcoin loans work and selecting the right platform are crucial steps for anyone considering this financial tool.

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