Bitcoin has shown itself among the best performing assets in the past decade. In 2023, bonds outperformed the S&P 500, high-yield corporate bonds, and gold, rising as much as 156% in one year.
Today, demand for Bitcoin is reaching record levels as the approval of new spot Bitcoin ETFs has created a wave of institutional interest.
Despite being described as a risky and volatile asset, Bitcoin remains a profitable investment, especially for early investors. When it was launched in 2009, it was practically worthless. In 2010, it was trading at $0.10.
By 2013, it had reached highs of $250, a 250,000 percent growth for early investors. Those who invested in 2017 will be looking at gains of more than 6,700 percent in 2024 as the cryptocurrency asset briefly touched $70,000 recently.
With this kind of growth, it is no wonder that investors view it as a long-term investment, and favor HODL until it reaches new price highs.
However, any long-term Bitcoin holder knows that the path to profitability is not always smooth. Sometimes, you need to sell or take profits to maintain expenses or meet emergency cash needs.
As a result, you give up part of your Bitcoin holdings and reduce the potential for long-term gains. Those who intend to replenish their Bitcoin also end up buying back the asset at several times the original purchase price.
What if there was another way to access much-needed funds without selling your Bitcoin? Bitcoin loans offer a solution that provides access to liquidity without giving up your assets.
How does a Bitcoin loan work? Here, we dive into the unique mechanics of a Bitcoin loan. We discuss how the world's leading cryptocurrency is revolutionizing the world of finance beyond trading by providing alternative means of securing loans while retaining access to potentially higher returns in the future.
Understanding Bitcoin and Cryptocurrency Lending
Bitcoin loans are a form of cryptocurrency lending. Cryptocurrency lending platforms allow Bitcoin investors to borrow against their deposited assets. They can also lend out their Bitcoin holdings to earn interest on cryptocurrency rewards. In 2020, cryptocurrency lending platforms started gaining significant momentum. It has since expanded to hold billions in total value locked (TVL) across multiple platforms.
You can divide cryptocurrency lending into two components. Cryptocurrency deposits or BTC that earn interest and crypto loans. Deposit accounts on these platforms behave like regular bank accounts. You can deposit BTC and earn interest. The platform can use the deposited funds to lend to borrowers or for other investments, similar to the way a bank works.
Typically, cryptocurrency loans are offered as secured lending products. It requires users to make a minimum deposit of 100 percent to get the loan. Some require up to 150% and therefore become over-collateralized loans.
How to secure a bitcoin loan
A Bitcoin-backed loan, or Bitcoin, is a US dollar loan collateralized by BTC. To secure this type of loan, you can send Bitcoin to the lending platform as collateral. In return, you get a loan in stablecoins or US dollars.
The mechanics of Bitcoin-backed loans are similar to traditional secured loans, except that Bitcoin is the collateral. Such loans eliminate the need for extensive credit checks. The steps include account creation, brief setup, key upload, and loan application submission. On decentralized platforms, the process can be more straightforward.
Once your BTC deposit is confirmed on the blockchain, the USD or equivalent stablecoin is sent to your bank account or cryptocurrency wallet. Interest on the loan is paid at regular intervals. For example, interest payments could be due every 30 days and continue until the loan matures. The final interest and principal amount will be paid at maturity.
The amount you receive depends on the value of your BTC holdings and the platform's LTV (loan-to-value) ratio. The LTV ratio is determined based on the risk factors associated with cryptocurrency market volatility. If the value of Bitcoin declines, the platform may ask you to add more collateral to equal the amount borrowed. If you do not add collateral, you risk having your Bitcoin holdings liquidated.
Factors to consider when applying for a Bitcoin-backed loan
Bitcoin loans are not risk-free. Although they offer many benefits, keep the following in mind before you decide to lend your Bitcoin holdings:
Risks associated with remortgaging
Some Bitcoin lenders mimic the operations of banks, which means your deposited Bitcoin may be subject to re-pledge. Remortgaging is the process of lending a client's assets provided as collateral.
Therefore, BTC is at risk. The lending platform, in turn, earns interest by using your digital assets for various purposes, including re-lending. Some bitcoin-backed loan providers lend their bitcoins to third parties.
By remortgaging, the loan provider receives a benefit from the borrower's interest payments and the proceeds from lending BTC collateral to other parties. The lender passes on a portion of the interest to the borrower in US dollars through a marginally lower interest rate. However, some of the borrower's collateral – or even 100 percent – is at risk.
Borrowers are unaware of the counterparty risks surrounding Bitcoin-backed loans. Their holdings are exposed to multiple layers of counterparty risk. Lenders who remortgage collateral thus expose borrowers to risk when either party becomes insolvent.
Fortunately, some Bitcoin loan providers do not remortgage. It is up to the user or client to determine the features of the lending platform and decide how much risk they can take.
Annual Percentage Rate (APR)
The annual percentage rate, also known as APR, is the annual interest rate generated by the amount charged to borrowers or paid to investors. APR is a ratio that represents the annual cost of funds over the life of the loan or income earned from an investment.
In other words, it calculates the total cost of the loan annually. The value includes additional costs or fees associated with the transaction. APR does not take composition into account.
The APR provides platform users with a definitive number to compare investment products and lenders. Some lending companies offer low interest rates but charge high origination fees. This feature will significantly increase your APR. A higher APR means that it is more expensive for the borrower to originate multiple loans in one year.
The short-term loan will promise low interest rates. However, you need to check the set-up fees. Taking out a twelve-month loan with a slightly higher interest rate with a one-time origination fee will be cheaper than taking out a three-month loan with a 1 percent origination fee and renewing it.
LTV requirements
LTV or loan-to-value requirements must be taken into consideration when taking out a loan backed by Bitcoin. For example, an LTV of 40% means that a $10,000 loan would require $25,000 worth of BTC as collateral. This ratio aims to prevent the liquidation of collateral as the market price fluctuates.
Some lenders offer lower interest rates and lower LTV ratios. The lower loan-to-value ratio can range from 20 to 30 percent. Therefore, customers must deposit more Bitcoin to access the loan. This practice is done to have the ability to lend or remortgage collateral to others. Another reason for a lower loan-to-value (LTV) ratio is that higher collateral means less risk when lending.
Capital Guarantee (CTP) versus Loan-to-Value (LTV)
CTP, or collateral-to-capital ratio, is the inverse of LTV. For example, a maximum value of 40 percent is equivalent to a CTP of 250 percent. CTP helps users understand the current status of their collateral ratio. This value is useful when the price of BTC is falling.
Tax implications
Tax legislation regarding Bitcoin loans is still evolving. It is important to consult a tax professional regarding your potential tax liabilities, even if it is reasonable to expect that Bitcoin-backed loans will be treated similarly to traditional lending practices by the IRS.
The IRS announced in 2014 that virtual currencies would be treated as property when it comes to tax treatment.
Therefore, they trigger capital gains taxes when sold. However, borrowing against Bitcoin or cryptocurrencies will not trigger these taxes.
However, it is best to consult a tax expert regarding current and future tax issues related to Bitcoin loans.
What are the benefits of Bitcoin loans?
Bitcoin-backed loans offer many advantages, especially for long-term holders. The most obvious advantage is access to liquidity without having to sell BTC holdings. Bitcoin loans safeguard your holdings of digital assets. It also saves you capital gains tax as a result of not selling.
Furthermore, Bitcoin loans tend to offer a higher level of privacy than loans from traditional financial institutions. They typically do not require extensive credit checks and disclosure of extensive personal information. To secure a Bitcoin loan, you will only reveal minimal information to verify identity.
Another benefit of Bitcoin loans is speed. Some bitcoin-collateralized loans can be obtained within days, hours, or even minutes.
Bitcoin Loans: An alternative to selling your Bitcoin
Owning Bitcoin offers many advantages, including achieving significant growth in your investment and owning a rare asset that doubles as a decentralized payment method.
Hence, it is understandable for Bitcoin holders to think twice before selling Bitcoin to fund urgent expenses with USD. However, we all have to take care of our financial needs.
Bitcoin-backed loans bridge the gap between owning a profitable investment with high growth potential and temporarily meeting paper expenses. Many platforms offer Bitcoin-backed loans with different features and requirements. You should evaluate the pros and cons of each platform and use those that balance the risks with the most significant financial benefits.
When you hold your Bitcoin long-term, you can explore new products and services that protect your wealth because they provide a way to meet financial needs, invest in other assets, and take advantage of business opportunities.
This is a guest post by Ivan Serrano. The opinions expressed are entirely their own and do not necessarily reflect the opinions of BTC Inc or Bitcoin Magazine.
