New Trend: What is Bitcoin-Backed Loan and How to Get It?

Bitcoin-backed loans are an innovative take on traditional lending and combine it with the world of cryptocurrency. These loans offer a unique way for Bitcoin holders to access liquidity by allowing them to use their digital assets without selling them.

The proliferation of crypto lending platforms has streamlined the process and made such loans increasingly accessible.

What is a cryptocurrency loan?

Crypto lending is revolutionizing the way individuals interact with digital assets and offering exciting new ways to borrow or even invest with cryptocurrencies. At the heart of this system are lenders who deposit cryptocurrencies into lending platforms to earn high interest, surpassing traditional savings accounts due to market flexibility.

Debtors, on the other hand, gain access to capital without liquidating their crypto assets. Borrowers can secure loans in stablecoins or fiat currencies, often by providing collateral in the form of other cryptocurrencies, thus unlocking liquidity while maintaining ownership of their assets.

A key driver of this innovation is the rise of decentralized finance (DeFi) platforms, which use smart contracts to automate the lending process, eliminate the need for intermediaries, and increase transparency and security. Demonstrating the potential of DeFi to transform financial services, platforms such as Aave, Compound, and MakerDAO have become leading players in this space.

Lending Bitcoin in DeFi often involves using Wrapped Bitcoin (WBTC), which is compatible with smart contract networks such as Ethereum, Arbitrum, Polygon or Solana, allowing users to participate in decentralized lending.

Crypto loan types

Crypto loans are often offered as secured loans, meaning users’ crypto assets secure them. Just like a mortgage or car loan, security can be seized as payment if users don’t repay their loans.

Some platforms enforce overcollateralization by only allowing users to borrow up to a certain percentage of their deposited collateral. In over-secured loans, the value of the collateral exceeds the value of the loan, which can reduce risk for the lender and secure better loan terms.

In contrast, these loans, also known as unsecured loans, do not require any collateral. At the same time, credit approval processes for these loans depend on factors such as a history of responsible credit use and on-time payments.

When using cryptocurrency as collateral, users have two main options. First, centralized finance (CeFi) loans involve borrowing from a crypto or blockchain company, which operates similarly to traditional financial institutions controlled by a private central authority, offering greater stability and security.

Second, DeFi loans allow borrowers to access funds through decentralized blockchains. Managed by an open-source network rather than a single entity such as a bank or government, DeFi products allow users to directly manage their digital assets. However, lenders can take necessary measures to secure the loan if necessary.

Study Methodology: Understanding Bitcoin-backed loans

Bitcoin-backed loans operate on the principles of collateral management, serving as a secure gateway for users to access fiat or stablecoins to benefit from the collateral value of Bitcoin. This financial avenue is respected for its security, with Bitcoin’s comparative stability against other crypto assets and its ability to unlock the highest loan-to-value (LTV) threshold second only to stablecoins.

The LTV ratio measures the loan amount based on the assessed value of the asset being purchased. It is an important indicator for lenders to assess risk, and lower LTV ratios generally indicate lower risk.

Numerous platforms in both the CeFi and DeFi ecosystems support Bitcoin-backed loans. These platforms generally prioritize resilient security measures and adhere to sustainable security standards that resonate with the ethos of Bitcoin holders.

Among the numerous options available, some Bitcoin native solutions emerge through credit products built on top of Layer-2 bitcoin networks, such as Stacks. While these products provide Bitcoin users with a degree of self-custodial access, they inherently rely on the security of the Bitcoin network.

How to get a Bitcoin-backed loan?

Borrowers should understand the collateral management process, loan eligibility criteria, potential loan default consequences, and available financing options before securing such a loan.

Step 1: Borrower applies for loan

Borrowers start by applying for a loan through a platform that specializes in Bitcoin-backed lending. During the loan application process, they provide details about collateral, usually Bitcoin, and specify the desired loan amount.

Step 2: Borrower deposits Bitcoin into a lending platform’s crypto wallet

Once approved, the borrower deposits the specified amount of Bitcoin into a crypto wallet provided by the lending platform. This Bitcoin is held in escrow and acts as collateral for the duration of the loan.

Step 3: Lending platform determines LTV ratio

The platform then evaluates the asset valuation of the Bitcoin collateral and determines the LTV ratio, which determines the maximum loan amount based on the value of the collateral. For example, if a borrower deposits $10,000 worth of Bitcoin and the LTV ratio is 50%, they can borrow up to $5,000.

Step 4: The loan payment process starts after approval

Once the loan is approved, the loan disbursement process begins with the borrower receiving the approved amount in the currency or stablecoin of their choice. Meanwhile, Bitcoin collateral remains securely held in the platform’s wallet. The borrower makes regular interest payments, usually monthly, throughout the life of the loan. The interest rate depends on several factors, including the loan amount, the borrower’s creditworthiness, and market conditions.

What happens to Bitcoin Collateral if the borrower misses a loan payment?

Once the borrower repays the principal amount along with any accrued interest, the Bitcoin collateral is returned to his wallet. However, if the borrower does not repay the loan on time, the loan can be restructured with refinancing options. In this case, the lending platform may initiate a margin call, requiring the borrower to deposit additional Bitcoin or risk their collateral being liquidated to cover the outstanding balance.

Benefits of Bitcoin-backed loans

It’s vital to weigh both the benefits and risks before considering Bitcoin-backed loans. A significant advantage lies in protecting Bitcoin assets. Users do not need to sell their Bitcoin to access cash. This allows them to maintain ownership of their digital assets and potentially benefit from future price increases while meeting current financial needs.

Additionally, crypto loans often offer quicker approval processes than traditional loans, providing quick access to funds, which can be particularly advantageous in situations where immediate liquidity is required to address financial obligations or opportunities.

Another benefit is the global accessibility and flexibility of Bitcoin loans, available worldwide regardless of geographic location or credit history. Users have the freedom to choose loan amounts, purposes and repayment options that enable them to access liquidity according to their individual financial needs and circumstances.

Moreover, lending Bitcoin on cryptocurrency platforms can provide users with attractive interest rates that often exceed those of traditional savings accounts. Additionally, borrowing against Bitcoin holdings can provide tax advantages by optimizing users’ financial approaches while reducing tax liabilities by bypassing capital gains taxes from selling Bitcoin.

Risks associated with Bitcoin loans

First, the inherent elasticity of the market and Bitcoin’s price fluctuations can be dramatic, creating risks for Bitcoin-backed loans. It leads to liquidation of the collateralized Bitcoin if its value falls below a predefined threshold. Price fluctuations in Bitcoin can significantly impact loan repayment obligations and require borrowers to develop careful risk management strategies.

Second, Bitcoin loan interest rates are subject to market fluctuations and expose borrowers to increased borrowing costs if interest rates rise over the life of the loan. Variability in interest rates can affect the overall affordability of the loan and impact borrowers’ financial stability over time.

The evolving regulatory environment creates uncertainty around Bitcoin loans, creating uncertainty in legal, availability and service terms. As regulations change, the availability and terms of Bitcoin loans may be affected. Borrowers should stay aware of these developments and adapt their risk strategies to manage potential impacts soundly.

Cryptocurrencies are not insured by traditional institutions, potentially leading to loss of collateral in the event of hacks or lender bankruptcy. Additionally, entrusting Bitcoin assets to lending platforms exposes borrowers to risks such as fraud, bankruptcy, and security breaches. It is crucial to choose reputable platforms with robust security measures and transparent policies to effectively mitigate platform-related risks. Conducting thorough due diligence and research can help borrowers identify trustworthy platforms and minimize the possibility of negative outcomes.

If cryptocurrency values ​​fall below certain thresholds, lenders may require additional collateral or liquidation of assets. Margin calls can occur suddenly and require borrowers to take immediate action to maintain their loan-to-value ratios, potentially leading to asset liquidation or additional collateral requirements.

Finally, the inability to trade or transact crypto assets while holding outstanding loan balances may create difficulties during price declines, effectively limiting access to or use of collateralized assets and restricting borrowers’ ability to respond to changing market conditions or financial needs.

So what do you think about crypto loans? Please share your ideas with me.

Stay safe.