At a time when the crypto market is experiencing sharp volatility in the midst of a bear market, the idea of taking a crypto backed loan looks so appealing to crypto investors who want to take advantage of the dip but lack liquidity. Although the idea is not a new thing, a lot of people do not know how the concept actually works. Most people think taking a crypto backed loan is just as easy as drawing a straight line. You lock up your crypto on the loan platform, obtain the equivalent loan you want, and then pay it back at the agreed time with interest. Easy, right?
But that’s far from the truth.
Most people who use crypto backed loans do so because they do not want to sell their crypto at the time, with the hope that the prices of their coins might increase in the future. However, most people often end up being liquidated by the loan platform even before the time for repaying their loans. This usually happens because the people who take these loans do not pay proper attention to the loan terms.
There are certain things you must bear in mind before taking a crypto backed loan. First, you need to know the liquidation threshold of your collateral. This can differ per platform and it established by by the loan to value ratio LTV. For example, using $10,000 worth of BTC to obtain a loan of $5,500 would mean a 55% liquidation threshold. Anything higher than this means your coins will be liquidated once the price drops to that level.
You may feel confident about repaying the loan as soon as possible without thinking about what happens if your liquidation level increases. After all, your collateral value is almost twice the loan you obtained. However, a 30% drop in the value of your collateral can happen at any moment, which can push the liquidation level higher and trigger automatic sales of your assets by the loan platform, even if the loan repayment date has not yet arrived.
Usually, there is a warning about this in the loan terms, but most people do not pay attention to it. When your collateral value decreases, your liquidation level increases, and at this point you are given a “margin call – 24 hours to cure.” This requires you to do one of two things: top up your collateral with an equivalent amount of crypto to restore the original value, or repay part of the loan you obtained. There are no other options. One of these two actions must happen, or part of your crypto will be liquidated to push the liquidation level back down.
The advantage is not with the borrower in this game. Consider the loan example mentioned earlier. If you have a collateral value of $10,000 worth of BTC for a loan of $5,500, and BTC drops by 30%, your collateral value drops to around $7,800. You are expected to repay an equivalent amount from the amount you borrowed to bring back the LVT, or that same 30% will be liquidated from your collateralized assets, which have already lost value. Meanwhile, your loan amount remains the same.
There are only a few things that could help anyone in this situation. Whenever you attempt to take a crypto backed loan, borrow less than 50% of the value of the collateral asset you are providing. This keeps the liquidation level lower and helps prevent automatic liquidation. Also, you should have extra collateral ready in case you receive a margin call notification. You must also be fast in executing this action if the need arises.
Crypto backed loans are good during a bull run because the sole reason for borrowing against your crypto is that you do not want to sell, at least not at the moment. Having someone else liquidate your assets when you only obtained a loan that is a fraction of the collateral value of those assets can be painful, especially when you are confident that the portion being liquidated could have been enough to cover the loan you borrowed if the assets eventually increased in price.