Blog | Cryptocurrency

Bitcoin Loans vs. Traditional Loans: Which Is Better for You?

A Quick Guide to How Bitcoin-Backed Loans Work

summary

• Bitcoin-backed loans allow you to borrow cash or stablecoins by using your Bitcoin as collateral.

• These loans let you retain ownership of your BTC while accessing liquidity.

• The loan is secured by the value of your Bitcoin, which is at risk of liquidation if BTC's price drops.

• You keep the borrowed funds even if your Bitcoin is liquidated.

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What Are Bitcoin Loans?

Many long-term Bitcoin holders are unaware that they don’t simply have to sell their BTC to spend its cash value. This is where Bitcoin loans come in.

Bitcoin-backed loans are a type of secured loan where you use your Bitcoin (BTC) as collateral. Basically, this means that you deposit your BTC with a lending platform (like Coinbase or Ledn) in exchange for a loan in USDC or other fiat/stablecoins.

The beauty of this type of loan is that your Bitcoin remains your property without selling the assets, but it can be liquidated if its value drops too low relative to the loan amount.

How Bitcoin Loans Work

In a nutshell, this is how Bitcoin loans work:

1. You deposit BTC as collateral.

2. You receive a loan in USDC, USD, or another currency.

3. If BTC’s value drops too much, your BTC may be sold to repay the loan.

Here's an example:

Let’s say you want to borrow $500. You would need to provide around $1,250 worth of BTC as collateral. Then that BTC would be held in the loan contract, and you’d receive 500 USDC. Once you pay back the 500 USDC, all of your Bitcoin is released back to you, or you can borrow again.

How Are Bitcoin Loans Different From Traditional Loans?

Bitcoin loans have several advantages that make them more attractive than traditional loans or payday loans. For one, there are no credit checks. Bitcoin loans don’t require a credit score; your BTC is the collateral.

Since you are providing your BTC, these loans have a faster approval time. Bitcoin loans are instant or near-instant. You can receive the stablecoins within a few minutes of agreeing to the loan terms.

Once you receive the USDC, you can use it however you want. Here are some ways you can use your USDC:

• Convert it into cash.

• Use it to fund/fuel a crypto debit card.

• Spend your stablecoin with services that accept it as a form of payment.

• Hold it to earn 4.1% APY on it if the loan is on Coinbase.

• Use it on yield-generating crypto platforms (such as AAVE) for small passive income.

Liquidation & Monthly Payments

Liquidation is one of the biggest risks with a bitcoin loan. Your BTC faces the risk of liquidation if its value drops too much below the price it held when you took out the loan. If that happens, then your BTC would be sold to repay the loan.

In a liquidation event, you still keep the stablecoins you borrowed, and you'd owe nothing further. You would even get back your BTC that wasn't sold, since they will only sell the amount to repay the loan and interest. This is how a collateralized loan works.

Here’s an example of what BTC would need to drop to for a loan of 500 USDC to get liquidated.

• Loan Amount: $500 USDC

• Collateral: $1,250 in BTC (40% LTV)

• Liquidation Threshold: 80% LTV

At 80% Loan-to-Value (LTV), the value of your $1,250 worth of Bitcoin must drop to $625 (because $500 / $625 = 80%).

If Bitcoin's price falls below this value, then your BTC is liquidated to cover the loan.

A common concern or misconception with BTC loans is individuals questioning what the payment amounts will be. But these are not like traditional loans; BTC loans have no monthly payments. You only owe interest, with repayment at the end.

It's the same situation as if you borrowed on precious metals.

Which is Better: Bitcoin Loans or Traditional Loans?

Bitcoin loans sound great, but are they better than traditional loans? Well, those involved in crypto long-term are likely to say an emphatic “yes”. For those with substantial BTC who don’t want to sell it but need liquidity, Bitcoin loans are their go-to when they need cash fast.

They don’t have to worry about losing the position they had at the time of purchasing their BTC either. If they sold their BTC for cash, it’d be subject to capital gains tax.

Traditional loans are better for those who don’t own BTC or who want lower interest rates.

To compare the two:

• Bitcoin loans have higher risk due to price volatility.

• Traditional loans have credit score requirements but no liquidation risk.

Pros of Bitcoin Loans

• Maintain your BTC ownership while accessing funds for emergencies or purchases.

• No credit check is required.

• Fast approval process (seconds or minutes).

• Flexible use of borrowed funds (use it however you like).

Cons of Bitcoin Loans

• Liquidation risk if BTC price drops.

• Interest rates can be high (depending on the platform).

• No ability to increase the loan without adding more BTC.

• You must trust the lending platform with your BTC.

Considerations With BTC Loans

There are things you'll need to consider before getting any form of crypto based loan.

• Penalty Fees - Be on the look out for any potential penalty fees for late repayment or exceeding the LTV ratio.

• Hidden Fees - Look for hidden fees in the loan agreement, there might be origination fees or withdrawal fees.

• Accrued Interest - Understand how interest is calculated and if it compounds over time.

• Bank Account Requirements - If you plan to convert your borrowed stablecoins into cash, you'll need to have a compatible bank account for receiving the cash.

• Interest Rates - Compare interest rates between platforms to find the most favorable option.

Passive Income Strategy with Bitcoin Loans

A popular strategy is to use crypto-backed loans to earn passive income. Here’s how:

How Coinbase Bitcoin Loans Work

1. Use Coinbase to borrow USDC against your BTC.

2. Holding the USDC on Coinbase earns 4.1 APY in passive income. However, you can take the USDC off the exchange and use it or place it in a yield-generating protocol.

3. Make sure the interest earned is higher than the interest you pay on the loan.

4. This way, your BTC can grow in value while your borrowed funds generate passive income.

Are There Other Crypto-Backed Loans?

Yes, other platforms offer crypto-backed loans using several different cryptocurrencies and across many different blockchains.

Platforms like Ledn and AAVE provide loans using altcoins like Ethereum or even stablecoins. But keep in mind, these loans can have higher risk depending on the volatility of the collateral that you use.

Risk of Altcoin Loans

Altcoin-backed loans are riskier because altcoins generally have much more volatility than Bitcoin. Rapid price drops can cause liquidations faster than Bitcoin loans. Choosing altcoins with lower market stability increases the risk of losing your collateral.

Is Borrowing USDC Against Bitcoin a Taxable Event?

No, borrowing USDC against your Bitcoin is not a taxable event. This is because you are not selling your Bitcoin, you are using it as collateral. You keep the ownership of your BTC, and taxes are not triggered until a taxable event occurs.

What is a Taxable Event?

• Selling BTC: If you sell or convert your Bitcoin to any other cryptocurrency or for cash, you must report a capital gain or loss.

• Liquidation of Collateral: If your Bitcoin is liquidated to repay the loan, this is considered a sale. You will owe taxes based on the difference between your cost basis and the sale price.

• Earning Interest or Rewards: If you earn interest on your BTC or the borrowed USDC, that income could be taxable as well.

Tax Advice With Bitcoin Loans

Keep in mind that nothing in this article is tax advice, and your tax liability could vary depending on where you live and your personal circumstances. Consult with tax advisors before making any investment decision.

Final Thoughts

BTC loans are great for those who intend to keep their BTC for the long haul. Due to the scarcity of Bitcoin, some find it better to keep growing their portfolio. Selling it is not only a taxable event, but it also means losing out on a limited resource. This is why crypto-collateralized loans have become so popular.

But they come with risks, including liquidation if BTC’s value falls. So always make sure to use this strategy responsibly, understand the platform’s terms, and never risk more than you can afford to lose.

(Disclaimer: This article is not financial advice and is intended for educational purposes only. It is important to conduct thorough research and only invest an amount that you are comfortable potentially losing. For personalized financial advice, consult a professional.)