What Is A Bitcoin Backed Loan?

As Bitcoin continues to monetise, we see more financial products built on the Bitcoin network or leveraging the asset’s value of Bitcoin. The more capital flows into Bitcoin, the more incentive for institutions and individuals to provide Bitcoin-related services.  

One of those products is Bitcoin backed loans; this product comes with several benefits that make it appealing to Bitcoin holders. However, like anything that involves Bitcoin, it is essential to understand the risks associated with Bitcoin lending before you apply.

How does a Bitcoin-backed loan work?

We are all familiar with the concept of a loan in the fiat world. We can access short term loans, payday loans, overdrafts and credit cards. These are typically unsecured loans and require a higher interest rate to compensate for the risk taken by the institution providing the capital. 

Then we get secured loans; these are loans that are tied to an asset. The asset could be a vehicle, business or home. In these instances, you would have longer repayment terms and higher values, but lower rates as the bank/financial institution still have an asset they can claim to cover part of the loan, reducing the risk. 

Bitcoin loans work a little differently in that they are over-collateralised.

What is over-collaterlaisation? 

Over-collateralisation (OC) is when a loan is issued on the provision of collateral worth more than enough to cover potential losses in cases of default. In a traditional market, a business owner seeking a loan could offer stock options, property or equipment worth 10% or 20% more than the borrowed amount.

These assets may not be liquid, but they have a particular value; the bank/institution would then take temporary ownership of the assets or issue a claim on said assets and then issue the cash requested. They can offer better interest rate terms since they know that should the business default on a loan. The bank/institution is confident of repayment by seizing the assets. 

In Bitcoin terms, where the asset’s fiat currency value can fluctuate at large percentage points each day, it becomes a little tricky to borrow. This is why institutions or individuals insist on over collateralisation at different LTV’s. 

What is LTV (Loan To Value)?

A loan-to-value (LTV) ratio assesses the lending risk financial institutions and other lenders examine before approving a loan. Since Bitcoin is still seen as a volatile asset, different institutions are willing to offer different loans to value rates. 

Typically we’ve seen LTV’s range up to 50%. 

So what does this mean? To make things easier, let’s say you have 1 Bitcoin valued at $60 000. You would like to take a loan against that Bitcoin. 

You lock it into a contract or send it to a centralised finance platform, and in return, you can borrow: 

• 50% – $30 000
• 40% – $24 000
• 30% – $18 000
• 20% – $12 000
• 10% – $6 000

Why would you want to borrow cash against your Bitcoin?

It may sound strange; I mean, why would someone only want up to half the cash value of their Bitcoin if they could sell it for $60 000 at spot? There are several benefits to borrowing against your Bitcoin that some traders prefer overtaking the cash by exiting their position.

Low-interest rates.

Since Bitcoin loans are secured by an asset, these loans tend to have lower interest rates when compared to unsecured personal loans and credit cards. As a result, they can appeal to someone who has Bitcoin they don’t plan to use or trade and want to save money.

Some may even consolidate their old unsecured loans with a Bitcoin backed loan instead due to its favourable terms. 

Quick funding.

Once you’re approved, you may be able to get your loan funds within hours.

No credit check.

In many cases, the Bitcoin lending platform won’t run a credit check when you apply since your collateral is your credit check. If your credit history is less than stellar or you have none, then Bitcoin backed loans could be a desirable alternative to access capital.

Reducing tax liabilities.

These are all compelling reasons to leverage your Bitcoin, but by far, the most popular reason is to avoid paying taxes and still accessing the capital. Depending on the country you live in, selling your Bitcoin could incur a hefty capital gains tax converting into your local currency. When taking out a loan, you are not selling; you are borrowing with the intent to pay it back. 

Sure, you get access to less capital, but the interest rates paid on the loan could be far less than the cash lost to tax. 

You are not losing your position.

Additionally, once the loan is repaid, you get to take ownership of your Bitcoin once again. We all know that markets cannot be predicted, and very few can time it correctly to sell at the top and buy back cheaper. Instead of trying to time the market to increase or maintain your position, Bitcoin backed loans allow you to access your capital without risking the amount of Bitcoin you own like you would if you were trading. 

What are the risks of Bitcoin backed loans?

While some key benefits to Bitcoin backed loans are appealing, nothing in life comes without a downside, and these are risks you need to consider before running out and getting a loan. 

Minimum borrowing requirements can be high. 

While platforms can vary, you may not have enough holdings to secure the minimum loan amount the lender offers. For instance, the minimum loan amount with some platforms is $10,000, and with a 50% maximum loan-to-value ratio, that means you need $20,000 or more in holdings to get approved. That could price you out of the market, should you not have $20 000 worth of Bitcoin to access the services of the platform. 

Repayment terms are short. 

Bitcoin loans typically have terms of 12 months or less however some are now pushing it up to three years. However, the vast majority of loans tend to be one year which means you don’t have a lot of time to repay them, especially compared with personal loans, which can offer longer terms. 

If you default on the debt, the platform may liquidate your holdings, which could result in a tax bill if your portfolio has gained in value since you first bought the digital assets.

Margin calls are a threat. 

A margin call occurs when the value of your collateral assets drops below a threshold set by the lender. If the price of your Bitcoin drops significantly—which is more likely with Bitcoin versus traditional assets due to the volatility of the market—you may need to deposit more into your account to keep your assets. If you don’t have additional Bitcoin on hand to fund the platform and maintain your LTV, the platform may choose to sell your holdings, which could affect your tax liability.

Third-party risk of centralised entities.

If you are using a centralised service, you have to accept that they have taken ownership of your Bitcoin. If anything were to happen to the platform, it is highly unlikely you’ll ever see your Bitcoin again. This is the risk you take with any centralised service, such as an exchange. 

Alternatively, you can borrow against your Bitcoin using a multi-sig approach and maintain your keys, but very few services opt for this, so your access to capital will be limited. 

Assets are inaccessible. 

As long as your loan is outstanding, you can’t use or trade your Bitcoin assets. In other words, if the price of your assets tanks, you’re stuck, and there’s no insurance against the loss.

The process of acquiring a Bitcoin backed loan. 

You would either approach a financial institution like a centralised finance service, decentralised finance service or peer to peer lending platform. 

• You, the borrower, connects with the Bitcoin lending platform requesting a crypto loan.
• The borrower offers Bitcoin as collateral for the loan. The platform accepts the loan and attaches the collateral. 
• You would then accept the loan terms, such as loan to value ratio, repayment period, margin call rates and interest on the loan. 
• The borrower will have to repay the entire loan before taking back the stakes in the collateral offered. 
• The lender funds the loan through the third party platform to the borrower.

That’s all there is to it; you now have the cash to do with as you please like you would any other loan. But remember, there’s no free lunch. If you don’t pay it back, you will have your loan liquidated, and the platform or lender will get to keep all of your Bitcoin. 

Bitcoin backed loans are an excellent option for certain situations, but they do not come without risk, so if you’re thinking about it, do more research on the platform you plan to use and borrow within your means to pay back.