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Investors are discovering new ways to put their Bitcoin (BTC -1.16%) holdings to use as the cryptocurrency becomes more widely accepted in the financial world. One such option is to use Bitcoin as collateral to secure a loan.
As Bitcoin continues to move forward, there is a growing desire among holders to access the asset’s liquidity without having to sell it. However, investors interested in obtaining a Bitcoin-backed loan will quickly realize that there are significant differences compared to traditional loans.
Here’s a detailed overview of what these loans entail to help investors make more informed decisions about Bitcoin-backed loans and the various options available.
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Like any other loan, the total value of the loan holders can obtain depends on the amount of collateral they can offer. Loans on some other assets, like some mortgage products with real estate as collateral, offer up to 97% loan-to-value (LTV), meaning they only need to offer up to 3% of the total loan as collateral. However, Bitcoin’s extreme price volatility means that those seeking to leverage their holdings will face more stringent borrowing terms.
Actual conditions vary between lenders and depend on market conditions, but it isn’t uncommon for Bitcoin loans to require LTV ratios as high as 50%. Under these circumstances, a potential borrower with $500,000 in Bitcoin could only borrow up to $250,000. Compare this to a prospective home buyer looking for a mortgage, where one might be able to borrow $485,000 toward a $500,000 home, assuming they meet specific criteria.
Not only do Bitcoin loan borrowers have to pledge more collateral, but the interest rates tied to these loans are generally much higher. While the average mortgage interest rate hovers around 8% today, Bitcoin borrowers should generally expect rates to be even higher than this, at times up to 15%.
Clearly, there are distinct differences to consider when looking to obtain Bitcoin-collateralized loans. But sometimes, personal conditions or financial goals warrant exploring Bitcoin loans. For those interested, there are two main routes to obtain Bitcoin loans: Centralized and decentralized lenders.
Centralized lending platforms provide a more traditional approach to obtaining loans using Bitcoin as collateral. These platforms, operated by a centralized authority such as a company or bank, are usually more straightforward and accessible. Typically, users can choose to receive loans in fiat currency or in stablecoins. The advantages of centralized lenders include a less complicated process, higher loan amounts compared to decentralized platforms, and potential access to a broader range of assets for borrowing. Popular centralized options include Unchained Capital, Binance, and Bitfinex.
However, the centralized platforms aren’t without their risks. During the recent crypto winter and market volatility hit, multiple crypto lenders became insolvent, ultimately putting borrowers’ assets at risk.
Decentralized Bitcoin loans, facilitated through decentralized finance (DeFi) blockchains like Stacks or Wrapped Bitcoin, offer an alternative to collateralize Bitcoin without having to trust or rely on a centralized intermediary. By locking up Bitcoin, users can generate a loan in stablecoins or other cryptocurrencies. This method substantially reduces counterparty risk, as the process is managed by smart contracts, providing transparency and security.
Like the centralized platforms, there are some drawbacks with DeFi lenders. The interest rates on DeFi loans are often not fixed and can be highly volatile. Additionally, the DeFi space can be complex, potentially posing challenges for less experienced users.
For investors seeking swift access to liquidity without triggering taxable events, Bitcoin loans can present a valuable financial opportunity. However, as with any financial decision, careful consideration of individual circumstances and alignment with personal goals is crucial.
Whether people are opting for centralized lenders with their established systems or decentralized platforms offering alternatives, understanding the collateralization process, loan terms, and associated risks like interest rates and potential smart contract vulnerabilities is paramount. Ultimately, the decision to leverage Bitcoin as collateral for loans demands a balance between financial objectives and risk tolerance.
RJ Fulton has positions in Bitcoin and Stacks. The Motley Fool has positions in and recommends Bitcoin. The Motley Fool has a disclosure policy.
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