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How Do Crypto-Backed Loans Work, and Are They Worth It?

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Jun. 28 2021, Published 5:30 a.m. ET

Cryptocurrencies have opened up more opportunities for investors. Aside from the obvious possibility of digital currencies offering wealth through appreciation, there are many ways for crypto players, both active and passive, to get involved. One growing sector is crypto-backed loans.

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Lending on collateral is not a new concept. Car loans are backed by the vehicle’s value, and mortgages use the value of the home as security in case of failure to pay. However, up until recently, securities have not been accepted as collateral themselves. Borrowers could rely on their overall portfolio as a means of collateral in the form of reserves, but lenders couldn’t seize those assets if a loan went south.

However, that’s all changing now as cryptocurrencies become a larger part of our overall financial landscape. Some lenders are using cryptocurrencies such as Bitcoin (BTC) and Ether (ETH) as collateral for fiat currency loans. So, how do these crypto-back loans work, and are they worth it?

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Getting a crypto-backed loan is quite simple

There are several reasons a lender would want to use cryptocurrencies as collateral. For one, cryptocurrencies are much more liquid than a car or house. Whereas a vehicle needs to be repossessed and a house foreclosed and resold to recoup losses, digital currencies can be transferred instantly.

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Once a crypto-backed loan is approved, the cryptocurrency used as collateral is then frozen by the lender. The borrower can’t sell the crypto or exchange it for other currencies. For the duration of the loan, both the borrower and the lender are subject to the cryptocurrency's volatility.

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The borrower makes equated monthly installments for the details of the loan. When the loan is fully paid off, the lender then releases the cryptocurrency back to the borrower, who is free to sell or exchange it as they please.

Crypto loans can also work in reverse. Lenders can issue promissory notes on cryptocurrencies. When the borrower pays off the loan, the lender will then release the cryptocurrency for the borrower to sell, trade, or hold.

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Are crypto-backed loans worth it?

A major downside of crypto-backed loans is being stuck holding a cryptocurrency and not being able to sell it or trade it for another. Crypto’s notorious volatility makes it crucial to be able to change your position at a moment’s notice.

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However, crypto-backed loans do have some benefits: using your current crypto portfolio to leverage the purchase of an equal number of crypto tokens all at once can maximize market returns.

For investors who like to hold their crypto assets in a wallet, obtaining crypto loans against their collateral to receive fiat currency is a great way to avoid taxes on gains. Crypto loans also open the arbitrage trading window for both lenders and borrowers. Arbitrage trading can be carried out between decentralized and centralized exchanges. Users can borrow dollars at a rate lower than the decentralized exchange's, trade it on a centralized exchange for a cryptocrrency, and then lend it on the decentralized exchange to earn an arbitrage fee.

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