How do Bitcoin loans work?

Bitcoin has emerged as one of the best-performing assets over the past decade. In 2023, it surged a whopping 156% in one year, outpacing the S&P 500, high-yield corporate bonds, and gold.

Bitcoin demand today is at an all-time high as institutional interest grows with the approval of new spot Bitcoin ETFs.

Despite being called a risky and volatile asset, Bitcoin remains a profitable investment, especially for early investors. It was virtually worthless when it launched in 2009. In 2010, it was trading at $0.10.

It hit a high of $250 in 2013, representing a 250,000% growth rate for early investors. Those who invested in 2017 would expect to see gains of over 6,700% in 2024, as the cryptocurrency asset recently briefly reached $70,000.

With this kind of growth, it’s natural for investors to view it as a long-term investment and prefer to “HODL” it until new highs are reached.

However, long-term BTC holders know that the road to profitability is not always smooth. Sometimes you need to sell or take a profit to sustain your expenses or meet urgent cash needs.

As a result, you give up part of your BTC holdings and reduce your long-term profit potential. The intention to replenish Bitcoin ends up repurchasing the asset for many times the original purchase price.

What if there was another way to access the funds you desperately need without selling your BTC? Bitcoin lending provides a solution to access liquidity without giving up your holdings.

How does a Bitcoin loan work? Here we will look at the unique mechanism of Bitcoin lending. We discuss how the world’s leading cryptocurrency is revolutionizing the world of finance beyond trading by providing alternative means of securing loans while maintaining 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 BTC investors to borrow their deposited assets. You can also borrow your BTC holdings to earn interest on your cryptocurrency rewards. In 2020, cryptocurrency lending platforms began to gain significant traction. It has since expanded to hold billions of dollars in Total Value Locked (TVL) across multiple platforms.

Cryptocurrency lending can be divided into two components: Cryptocurrency or BTC deposits eligible for interest and cryptocurrency loans. Savings accounts on these platforms work like regular bank accounts. You can deposit BTC and earn interest. The platform can then use the deposited funds to lend out to borrowers or make other investments, similar to how a bank operates.

Cryptocurrency loans are typically offered as secured loan products. To avail the loan, users must deposit at least 100%. Some require up to 150%, making it an over-collateralized loan.

How to secure a Bitcoin loan

Bitcoin or Bitcoin-backed loans are U.S. dollar loans backed by BTC. To secure this type of loan, you send BTC as collateral to the lending platform. In return, you receive a loan in stablecoins or US dollars.

The mechanism of a Bitcoin collateral loan is similar to a traditional collateral loan, except that BTC is the collateral. These loans do not require an extensive credit check. Steps include creating an account, brief onboarding, uploading keys, and submitting a loan application. On a decentralized platform, the process can be much simpler.

Once your BTC deposit is confirmed on the blockchain, US dollars or an equivalent stablecoin will be transferred to your bank account or cryptocurrency wallet. Interest on the loan is paid regularly. For example, interest is payable every 30 days and continues until the loan maturity date. Final interest and principal are paid on the maturity date.

The amount you receive is based on the value of your BTC holdings and the platform’s loan-to-value (LTV) ratio. The LTV ratio is determined based on risk factors related to the volatility of the cryptocurrency market. If the value of Bitcoin falls, the platform may require you to add more collateral to equalize the amount borrowed. If you do not add collateral, you risk having your BTC holdings liquidated.

Factors to Consider When Applying for a Bitcoin-Secured Loan

Bitcoin loans are risk-free. Although it offers many benefits, consider the following before deciding to lend your BTC holdings:

Risks Associated with Rehypothesis

Some Bitcoin lenders mimic a bank’s process, allowing deposited BTC to be re-collateralized. Re-mortgage is the process of lending a customer’s assets posted as collateral.

Therefore, BTC is at risk. The lending platform then leverages the digital assets for a variety of purposes, including re-lending, to earn interest. Some Bitcoin-secured loan providers lend their customers’ Bitcoin to third parties.

Through re-collateralization, the loan provider earns interest both from the borrower’s interest payments and from the proceeds of lending the BTC collateral to another party. The lender passes on a portion of the interest to the US dollar borrower through a slightly lower interest rate. However, some or even 100% of the borrower’s collateral is at risk.

Borrowers are not aware of the counterparty risk associated with BTC collateralized lending. Their holdings are exposed to multiple layers of counterparty risk. Lenders who remortgage collateral therefore expose the borrower to risk if either party becomes insolvent.

Fortunately, some BTC loan providers do not offer remortgage. It is up to the user or customer to choose the features of the lending platform and decide how much risk they are willing to take.

Annual Percentage Rate (APR)

Annual Percentage Rate, also known as APR, is the annual interest rate generated by the total amount charged to the borrower or paid to the investor. APR is a percentage that represents the annual cost of funds over the life of a loan or return on an investment.

In other words, it annualizes the total cost of the loan. That value includes any additional costs or fees associated with the transaction. APR does not take compound interest into account.

APR provides platform users with a final number to compare investment products and lenders. Some loan companies offer low interest rates but charge high fees. This feature significantly increases your APR. A higher APR means it costs the borrower more when taking out multiple loans a year.

Short-term loans promise low interest rates. However, you need to check the origination fee. It will be cheaper to get a 12-month loan at a slightly higher interest rate with a one-time origination fee than to get a 3-month loan with a 1% origination fee and then renew it.

LTV Requirements

When taking out a Bitcoin-backed loan, you should consider LTV, or loan-to-value requirements. 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 liquidation of collateral due to market price fluctuations.

Some lenders offer low interest rates and low LTV ratios. Low LTV percentages can range from 20 to 30 percent. Therefore, customers need to deposit more BTC to avail the loan. This practice is done to gain the ability to lend or remortgage the collateral to others. Another reason for a low LTV is that higher collateral means less risk when lending.

Collateral to Principal (CTP) and Loan to Value (LTV)

CTP, or collateral-to-principal ratio, is the reciprocal of LTV. For example, if your LTV is 40%, your CTP is 250%. CTP helps users understand the current status of collateral ratios. This value plays an important role when the BTC price falls.

Tax Impact

Tax laws regarding Bitcoin lending are still evolving. Although it is reasonable to expect that BTC-backed loans will be treated similarly to the IRS’s traditional lending practices, it is important to consult with a tax professional about possible tax liabilities.

The IRS declared in 2014 that it would treat virtual currencies as property for tax purposes.

Therefore, capital gains tax will be due upon sale. However, borrowing against Bitcoin or other cryptocurrencies does not incur such taxes.

Nonetheless, it is best to consult a tax professional regarding current and future tax issues related to Bitcoin lending.

What are the benefits of Bitcoin lending?

Bitcoin-backed loans offer several benefits, especially for long-term holders. The most obvious advantage is that you can access liquidity without having to sell your BTC holdings. Bitcoin loans preserve your digital asset holdings. You can also save on capital gains taxes by not selling.

Additionally, BTC loans tend to offer a higher level of privacy compared to traditional financial institutions. They generally do not require extensive credit checks and extensive disclosure of personal information. To secure a Bitcoin loan, you must disclose only the minimum amount of information to verify your identity.

Another benefit of Bitcoin lending is speed. Some Bitcoin-backed loans can be obtained in days, hours, or even minutes.

Bitcoin Lending: An Alternative to Selling Bitcoin

Owning Bitcoin offers many benefits, including generating significant growth in your investment and having a scarce asset that doubles as a decentralized payment method.

This makes holders think twice about selling BTC to finance urgent expenses in US dollars. However, we all need 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 fiat-backed expenses. Several platforms offer Bitcoin-collateralized loans with different features and requirements. You should evaluate the pros and cons of each platform and use one that balances risks with the most important financial benefits.

Holding Bitcoin long-term allows you to explore new products and services that protect your wealth by providing a way to meet your financial needs, invest in other assets, and take advantage of business opportunities.

This is a guest post by Ivan Serrano. The opinions expressed are solely personal and do not necessarily reflect the opinions of BTC Inc or Bitcoin Magazine.