Discover the ins and outs of crypto borrowing or lending with this guide. Learn how to leverage assets using lending platforms, and navigate taxes for crypto loans.
Over recent years, the cryptocurrency and decentralized finance (DeFi) revolution are transforming the traditional financial landscape. Crypto borrowing is a significant part of this exciting transformation, providing seamless ways to leverage crypto assets for liquidity, maintaining privacy, and eliminating the need for traditional KYC processes.
In this article, we provide an in-depth view of the mechanics behind crypto borrowing and discuss its tax implications to help you seize the power of DeFi to your advantage.
What is Crypto Borrowing or Lending?
Crypto borrowing and lending revolve around the exchange of digital assets with an agreement to return them over time.
Crypto holders or lenders can lend their digital assets through a DeFi platform to earn an attractive interest income. This interest is often significantly higher than what you might earn in a traditional savings or time deposit account in a regular bank.
On the flip side, borrowers leverage their crypto assets as collateral to secure loans. The unique aspect of borrowing using crypto is the ability to take out a loan without credit checks, income statements, or lengthy approval processes that are commonplace in conventional banking systems. Borrowers can get instant loans by simply providing collateral, which is often higher in value than the loan to mitigate the lender's risk.
How Crypto Lending Works
In crypto lending, an investor lends their cryptocurrency to another party, usually through a lending platform, in return for interest income, also known as “crypto dividends”.
These platforms work as intermediaries, securing collateral from borrowers to reduce the risk for lenders. The collateral, typically in a high-value cryptocurrency such as Bitcoin (BTC) or Ethereum (ETH), acts as an insurance policy for the lender, protecting them from defaults.
The platforms then use the deposited crypto from the lenders to give out loans to the borrowers against their collateral.
For instance, consider a scenario where you own 1 Bitcoin. Rather than having it sit idle in your wallet, you deposit it into a crypto-lending platform. A borrower, who has put up their crypto as collateral, then takes a loan from the platform.
During the loan term, you receive interest payments, let's say at a rate of 6% annually. At the end of the loan term, or when the borrower repays, you receive your Bitcoin back, having earned additional income during the lending period.
How to Take A Crypto Loan?
Taking a crypto loan involves depositing collateral (usually a high-value cryptocurrency) into a lending platform.
This deposit allows you to borrow funds up to a certain percentage of your collateral's value without triggering any taxable event. This ratio, known as the Loan-to-Value (LTV) ratio, is a critical measure in crypto borrowing, protecting lenders from sudden drops in the value of the collateral.
It is recommended that the loan-to-value ratio should not exceed 80%. In the case of an LTV more than 80%, borrowers may be faced with higher borrowing costs, private mortgage insurance, and loan denials.
For example, if you own 1 Bitcoin worth $50,000, and you need to access $20,000 in cash, you could sell part of your Bitcoin, but it would trigger a capital gains tax event.
Alternatively, you could deposit your Bitcoin into a crypto lending platform, borrow the $20,000 you need, and keep your whole Bitcoin. If Bitcoin's price increases during your loan term, you get the full benefit of that price appreciation when you get your Bitcoin back, minus the interest paid.
How Crypto Lenders Address the Volatility of Collateral
Given the high volatility of cryptocurrencies, lenders implement protective measures. An essential tool is the maintenance of a conservative LTV ratio.
Furthermore, lenders continuously monitor these ratios and require borrowers to increase their collateral if the value decreases significantly, a process known as a margin call.
If the borrower cannot meet the margin call, the lender may sell a portion of the collateral to maintain the loan's safe LTV ratio.
Tax Implications of Crypto Loans
In most regions, borrowing using crypto itself doesn't trigger a taxable event. However, selling borrowed crypto for fiat or trading it for other cryptocurrencies may be subject to taxes. For lenders, earning interest from loaning crypto is usually considered ordinary income and is taxable.
As with traditional loans, the interest paid for the crypto loans can also be deducted as expenses for any business. However, this doesn’t apply if the crypto loan is taken for personal reasons.
The tax laws may vary depending on your jurisdiction, so always consult a local tax professional or utilize crypto tax software for accurate compliance.
How To Report Your Cryptocurrency Taxes?
Reporting your cryptocurrency taxes accurately can be complex due to multiple transactions and varying tax laws.
This is where crypto tax software like Kryptos can help.
Kryptos simplifies crypto tax reporting by automatically importing your transactions from multiple wallets, calculating your gains and losses, and generating tax reports tailored to your jurisdiction.
Additionally, get access to tax-saving strategies and report your taxes like a pro. To get started, Sign Up on Kryptos for free.
FAQs
1. Can you make money borrowing crypto?
A: Yes, you can potentially make money by borrowing crypto, but it requires strategy and a thorough understanding of the market. Traders often borrow crypto to leverage their trading capabilities. For example, by taking out a crypto loan, a trader might increase their position in a promising cryptocurrency and potentially profit from its price increase. This strategy is known as 'leveraged trading'. However, it involves significant risk as market volatility could lead to losses, particularly if the value of the borrowed crypto falls.
2. How do I borrow against crypto?
A: Borrowing against crypto involves a few steps:
- Start by choosing a reputable crypto lending platform. Research the platform's terms and conditions, interest rates, and security measures.
- Deposit your cryptocurrency as collateral. The amount you can borrow will depend on the value of this collateral.
- Submit a loan request specifying the amount you wish to borrow.
- If approved, the loan amount will be transferred to your wallet. You will need to repay this loan plus interest within the agreed term.
3. Can I borrow crypto with no money?
A: Generally, to borrow crypto, you need collateral, often in the form of other cryptocurrencies. So, technically, you need to possess some value in crypto assets to leverage a crypto loan. However, the value of your collateral doesn't have to be in cash; it could be in Bitcoin, Ethereum, or other cryptocurrencies.
4. What are the benefits of borrowing crypto?
A: Borrowing crypto has several benefits including:
- Leverage for Trading: Borrowing allows traders to leverage their positions, potentially leading to higher returns.
- Liquidity: Crypto owners can get immediate liquidity without selling their assets.
- No Credit Checks: Traditional loan procedures require a credit score check, but crypto loans are typically approved based on the value of the collateral, not the borrower's credit score.
- Interest Rates: Crypto loans can sometimes offer more competitive interest rates than traditional loans.
5. What is the borrowing rate for crypto?
A: The borrowing rate for crypto, also known as the interest rate, varies between platforms and depends on several factors, including the loan term, the loan-to-value ratio, and market demand. The rate ranges from 3% to 8% in most cases, while stablecoin rates are typically higher, ranging from 10% to 18%.