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Should you borrow against crypto? Here are the risks

Should you borrow against crypto? Here are the risks
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Like a house, a car, or any other investment, your cryptocurrency can serve as a security for crypto loans, which are loans that can have low interest rates, same-day financing and no credit check.

What is the downside? If the value of your crypto drops, you may need to pledge more cryptocurrencies.

“This would be the main drawback of cryptocurrencies,” says Travis Gatzimir, a certified financial planner and founder of Kinetix Financial Planning near Dallas. “It is not a regular, stable asset that you would use to borrow.”

Despite the risks, cryptocurrency – and borrowing against it – has become a popular topic on public forums like Reddit and YouTube. But is a crypto loan right for you?

What is cryptocurrency?

Cryptocurrency entered the financial dialogue in 2008, with an anonymous programmer’s white paper on the concept of bitcoin.

Bitcoin is a cryptocurrency, or a digital form of money. It might sound complicated – and it can be depending on how you use it – but it’s basically digital tokens rather than physical money. They can be exchanged for goods and services on the blockchain, a digital ledger that keeps track of every Bitcoin transaction.

“The idea is supposed to be very simple,” says Ariel Zetlin-Jones, associate professor of economics at Carnegie Mellon University in Pittsburgh.

He watches: Are crypto stocks and meme a fad?

Throughout history, we have accepted physical tokens in exchange for goods and services, believing that we can then trade these tokens as money for other goods and services in the future. Blockchain and bitcoin facilitate the same type of transactions but without the need for physical tokens, says Zetlin-Jones.

What is a cryptocurrency loan?

A crypto loan is a type of secured loan, similar to a car loan, where you pledge an asset to secure financing.

In this case, the cryptocurrency is the asset offered to the lender in exchange for cash that you will pay back in installments. If you fail to repay the loan, the lender will liquidate the cryptocurrency or cash it in.

Cryptocurrency lenders such as BlockFi, Celsius, and Unchained Capital have relatively low annual percentage rates and loan terms of one to three years, but the minimum loan amounts are high.

For example, BlockFi crypto loans start at 4.5% APR on one-year loans, but the minimum loan amount is $10,000.

Why Borrow for Cryptocurrency?

A crypto loan might make sense if someone owns a large amount of cryptocurrency and wants to liquidate it without having to sell and possibly pay taxes on it, says Gatzemeier.

This money can then be used to buy or invest in a business, similar to borrowing with a personal loan.

In addition, borrowers can see lower interest rates with a secured cryptocurrency loan. And unlike personal loans, there is no credit check.

See also: Should I buy a Bitcoin ETF? Here’s what some pros say you should consider

Cryptocurrency loan problem

From April 2021 to October 2021 Bitcoin BTCUSD,
-6.19%
The price fluctuated between about $30,000 and $64,000.

The unstable value of the cryptocurrency can lead to a margin call, as the borrower must put up more cryptocurrencies to maintain the value of the initial pledge.

If the value of your pledged cryptocurrency drops below the limit set by the lender, you have a limited time to pledge additional crypto.

In cryptography, the ratio of the loan amount to the value of your collateral is called the loan to value, or LTV. For example, the maximum LTV value of a crypto lender BlockFi is 70%. At this point, borrowers have 72 hours to raise the cryptocurrency.

In addition to unstable pricing, crypto loans are not federally insured, says Gatzimmer. If you lose your money in a security breach, for example, compensation is not guaranteed.

Read: Coinbase abandons crypto-lending program after receiving threat from SEC lawsuit

Alternatives to Borrowing for Your Cryptocurrency

If you have a share in your house: With a home purchase line of credit, you can borrow up to 85% of the value of your home. Be careful, because you could lose your home if you don’t make the payments.

If you are looking for a lower interest rate: A 0% interest-free credit card can offer free financing for 14 to 18 months. However, note that after the introductory period, you can pay a high interest rate on unpaid balances.

If you have bad credit: Credit union loans usually have flexible rates and terms. They also consider your record as a member, which means they may have softer requirements.

If you need a small loan: A small personal loan – under $2,000 – is also a viable option. However, the rates may be high depending on your credit profile and income.

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Chanel Alexander writes for NerdWallet. Email: calexander@nerdwallet.com.

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