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Crypto Loan VS. Traditional Bank Loan, What’s the Difference?

According to a CNBC report, the average American generation Z and millennial per-head debts totaled over $100,000. And considering that they’re the more crypto-savvy individuals, it’s clear why crypto lending began gaining traction, especially during the 2020 pandemic that saw the majority jobless and unable to access traditional bank loans.

But, what exactly are crypto loans, and how do they work? Let’s find out!

What are Crypto Loans?

Crypto loans are simply digital currency loans gotten on different crypto exchanges or lending platforms. The idea of crypto lending is still growing in popularity, but it’s only a matter of time before it explodes considerably in the digital world.

The history of cryptocurrency loans is traceable to the 2020’s pandemic that saw world economies crumbling. Amidst the excessive borrowing during that period, exchanges began to open their crypto loan doors to people. 

By just having internet-connected devices, people were able to access fiat money via crypto loans instantly. And that was the beginning of the noble crypto loan phenomenon.

Crypto loans are most often collateralized, ensuring the lender’s security while helping the borrower access friendlier interest rates. That’s understandable since cryptocurrencies can be very volatile. 

However, it may be unfriendly for the borrower if the crypto price drops in a highly collateralized loan arrangement. While crypto loans vs. bank loans have their similarities and differences, the truth remains that both help you access funds.

Crypto Loans vs. Bank Loans

Generally, traditional bank loans are what we’re all more familiar with. It’s the system where a bank provides money or fiat currency to you with a percentage interest―which is an incentive to lend you their money. That said, let’s check out the differences between traditional bank loans and crypto loans.

#1. Security

Crypto loans are relatively new, and although they’re quite secure, many people are yet to open up to them. Bank loans have thrived for ages because of their perceived security, being that banks are regulated, government-backed institutions. 

#2. Currency Type

Crypto loans are often accessible in digital currency denominations, which may often require exchanging for fiat money. However, you borrow from the bank in fiat money denominations, which helps you deal with price volatility.

#3. Loan Amount

Bank lending provides you with relatively larger loans for mortgage, automobile purchase, etc. In contrast, it’s yet to be customary to access such huge loans in the crypto economy.

#4. Interest Rates

While cryptocurrency loans may not be as cheap as dust, they still offer competitive interest rates, sometimes below 10%. On the other hand, bank loans apply higher interest rates on average.

#5. Qualification for loans

Banks or Credit organizations often require you to have a good credit history before they offer you loans. This often sees people working for good credit for months upon months. Conversely, crypto lending cares nothing for your credit score. It may require collateral in a designated cryptocurrency, but it doesn’t bite you for bad credit or any such thing.

#6. Speed of Funding

Crypto loans are the faster option in terms of loan processing and release speed. Unlike the sluggish bank lending system that requires a lot of paperwork and vetting, you can get your crypto loan instantly or within hours–thanks to DeFi and smart contracts.

#7. Price Volatility

When you borrow from the bank, you receive your loan funds in fiat currency. So, you have little or no business with price volatility. However, most crypto lending platforms don’t lend you in fiat currency, so you have to battle with the volatility of the digital currency you borrow.

#8. Loan Term Flexibility

Banks operate a more rigid loan system than crypto lenders. How’s that? The bank sets the interest rate, the loan amount, and the loan duration. As a result, you have little or no control of your loan terms and conditions while your bank has the upper edge. 

On the other hand, crypto lending allows you to customize your loan preferences to a substantial degree.  You can choose your preferred digital currency or stablecoin, the loan-to-value ratio, etc.―which makes crypto loans more flexible and welcoming.

Source of Funds for Crypto Loans and Bank Loans

Traditional bank loans often follow what’s called the fractional reserve banking system. It works by reserving a given percentage of bank deposits as credit for borrowing customers. In essence, a certain fraction of funds deposited by customers and meant for loans is held in the bank reserve.

Although the fractional reserve banking system has been working for most banks, its major weakness is that it crumbles once customers make a mass withdrawal of funds. It becomes impossible to reimburse all customers, plus lenders are left aloof, and the entire economy collapses.

On the other hand, Crypto loans are more flexible and are mostly provided from the funds in liquidity pools. Liquidity providers (LP) fund liquidity pools with their crypto assets to support trading, lending, and other activities in crypto exchanges. As such, borrowers and traders access funds while LPs earn passive income on their “pooled” assets.

The crypto lending system, unlike bank lending, is self-governing. Therefore crypto lenders aren’t subject to liquidity level regulations. So, in case of a sudden and unfavorable market condition, investors must invest extra crypto in preventing liquidation.

Amazingly, crypto lending follows another system that involves ‘leveraging’ your crypto assets to borrow. For instance, you have $50K worth of Bitcoin, but you don’t want to sell it because you’d incur a tax of $10K. In that case, you can invest $10K in crypto as collateral and borrow against it. By doing so, your crypto keeps growing, you borrow the desired funds, and you pay no taxes.

You mustn’t sell your crypto for cash! Instead, you can borrow funds against your crypto assets on BlockFi or Coinbase, Celsius Network, Hodlnaut, etc. The goal is to enable you to use part of your crypto assets as collateral to get the funds you want with no taxes while still maintaining your crypto portfolio.

Crypto lenders contain illiquidity risks by issuing margin calls or initiating forced liquidations. A margin call is given when a crypto asset’s value drops so much that the platform can’t maintain the high loan-to-value ratios of the majority of its borrowers. In that case, the platform informs borrowers to increase the value of their collateral or risk liquidation.

Failure to meet the margin call may result in liquidizing sufficient collateral to bring the user’s loan-to-value ratio to normal. In essence, you will give up that fraction of your deposit, attract capital gains or losses, or pay extra transaction and broker fees. 

Conclusion

Traditional bank loans and crypto loans are both viable sources of funds. They share some similarities, both being financial systems, but they differ in many ways and have their associated risks, as seen above. That said, crypto lending is still in its emergent stages and should explode over the years.