The concept of using cryptocurrencies as loan collateral came up as the cryptocurrency market gained lots of popularity. On that note, the huge volatility and potential for massive value appreciation in the crypto space inspired the idea of leveraging digital assets to secure traditional loans.
Hence, using cryptos like Ether (ETH) and Bitcoin (BTC) or any other digital assets as collateral to receive a standard mortgage loan is referred to as a crypto-backed mortgage.
In these crypto-backed mortgages, the loan amount is mainly based on the crypto’s value, and the digital assets are retained as security until all the loan is paid back. To support safe and open transactions, the organizations utilize smart contracts and blockchain technology to support these cryptocurrency-collateralized loans, which use digital assets as security to acquire loans.
When Salt Lending, a decentralized lending platform, was launched in 2018, it became the first platform to offer crypto-backed mortgages. Borrowers could utilize their crypto holdings as security for loans via Salt Lending. Although that idea ran into many legal and regulatory challenges, the business later managed to change its offers.
Crypto-Backed Mortgage Types
The common type of crypto-backed mortgages include:
- Cash-out refinancing – Homeowners with current mortgages can refinance their properties using their crypto holdings as security to get funds for different uses.
- Purchase mortgages – These mortgages are mainly used for real estate financing and are secured using crypto as a security by the borrowers.
- Bridge loans – Borrowers utilize cryptocurrency collateral to secure a near-term bridge loan to cover the gap that exists between selling an existing property and buying a new one.
How Do These Crypto Mortgages Operate?
The process of acquiring a crypto-backed mortgage begins with the borrower giving their crypto to lenders as a security, with the lender calculating the maximum loan amount subject to the value of the provided collateral.
Crypto mortgages include using crypto holdings as security to bind a traditional loan or mortgage. The acceptability of the crypto is assessed before interest rates, term length, and payback terms are decided. Notably, the borrower deposits the agreed crypto amount into the lender’s escrow account after these terms are agreed.
In the escrow account, there is a third party. The third party keeps and manages the funds, documents, or property on behalf of both parties to a transaction until some form of criteria is satisfied.
The collateral is kept locked up for the entire time of the loan, and to limit volatility risks, borrowers often must have a particular buffer between the value of the collateral and the loan balance.
Related: What You Need to Know about Crypto Loans
Payments are normally made in fiat money. After repayment is finished, the borrower gets the collateral back. Nonetheless, a margin call (demand for extra collateral because of fluctuations in collateral value) may happen in case the value of the crypto drops steeply, in which case the borrower needs to service the needed margin.
When referring to loans with crypto as collateral, a buffer is a predetermined percentage difference that exists between the loan balance and the collateral value (cryptocurrency). For example, in case a borrower’s crypto collateral is valued at 1 BTC and the lender targets a 20% buffer, the borrower has to offer the collateral that is equivalent to 1.2 BTC (1 BTC 20% of 1 BTC), efficiently setting up a buffer against possible volatility risks in the entire loan tenure.
The buffer operates as a safety cushion for the borrower and the lender by preventing changes in the value of the crypto from instantly resulting in some margin calls or the liquidation of the provided collateral.
Crypto-Backed Mortgage Products
Crypto-backed mortgage products, including crypto collateral loans and decentralized finance (DeFi) mortgages, provide crypto owners with a chance to access liquidity without having to sell their digital assets.
Examples of crypto-backed mortgage products include:
Crypto Collateral Loans
Borrowers utilize their crypto holdings as security to acquire a loan. The real worth of the collateralized assets establishes the loan’s real value. Based on the nature of the collateral, various crypto-backed mortgages allow borrowers to pay back the loan and interest in crypto. Nonetheless, the lender might sell the collateral in case the borrower fails to repay the loan.
Stablecoin Mortgages
In this case, borrowers pledge stablecoins as collateral, which are digital currencies that are anchored to a stable asset like a fiat currency. This strategy helps preserve access to funds while mitigating the volatility that is linked to conventional cryptos.
DeFi Mortgages
Decentralized finance mortgages are issued using blockchain technology and smart contracts. DeFi protocols work autonomously on the blockchain, supporting trustless borrowing and lending without any intermediaries. For example, platforms such as Compound and Aave enable users to pledge their cryptocurrency assets as loan collateral.
Cross-Collateralization
To secure a viable loan, borrowers may use various cryptos as security. Distributing collateral among multiple assets can provide flexibility and help minimize risks.
Fractional Ownership Mortgages
By using blockchain technology, the borrowers can tokenize their real estate and provide fractional ownership, offering investors a new option to get involved in real estate ventures.
Related: How to Make Money with Crypto Loans: A Simple Guide
How To Acquire A House Using Crypto-Backed Loans
To purchase a house using crypto-backed loans, a user has to search for reputable lending firms that offer these kinds of mortgages. After selecting an appropriate platform, the user can then select a crypto for collateral.
The process of buying a house using these loans involves searching for the best lending platform, selecting collateral, loan submission, and considering possible legal ramifications.
While filing a loan application through the platform of choice, users have to include essential information, including ownership evidence for the collateral. On that note, the lending organization then assesses the collateral’s worth to determine the practical loan amount that can be offered.
Once the lender approves the loan, the borrower reads and accepts the terms and conditions, which cover items such as payback terms, interest rates, and all collateral requirements. After acceptance, the borrower gets the loan amount in crypto, fiat, or stablecoins, which can later be used to acquire a property.
To minimize the risks that are related to changes in the value of the collateral, it is important to remain diligent in monitoring possible market volatility. Moreover, to guarantee compliance with applicable laws in the region, people need to also consider the legal and tax implications of using cryptos for real estate transactions.
Benefits Of Crypto-Backed Mortgage
Crypto-backed loans let cryptocurrency holders unlock the value of their digital assets without having to liquidate them, hence possibly circumventing capital gains taxes. These loans also offer a way for obtaining conventional funding, opening up opportunities for investing in real estate and other entrepreneurial ventures.
Crypto-backed loans ensure that crypto holders do not lose their assets, which ensures that they avoid taxes and get a chance to acquire traditional investments. Also, they enhance financial inclusion and control over exposure to digital assets.
Financing options might be available via crypto-backed mortgages for anyone without access to traditional banking systems, thus promoting financial inclusion. Borrowers utilize these mortgages to control their exposure to cryptos and maybe hedge against considerable price changes.
Additionally, borrowers keep being exposed to potential crypto value growth while utilizing funds for useful purposes. Also, by bridging the traditional financial and digital spaces, mortgages increase the utility of cryptos in normal transactions.
Crypto owners can easily diversify their investment portfolio by securing traditional finance for projects such as real estate with their digital assets. The borrowers can use their assets directly as collateral instead of selling crypto on exchanges, avoiding possible trading challenges.
Related: How do Stablecoins Impact the Global Economy? (Roundtable Interview)
Risks That Come With Crypto-Backed Mortgages
The volatility of cryptos, which may result in massive swings in the value of the collateral during the loan term, is an integral cause of concern. The massive market fluctuations may result in margin calls, compelling borrowers to increase their collateral or risk liquidation.
Moreover, the regulatory infrastructure for financial products that are based on cryptos is still in its early stages, with various implications subject to the jurisdiction. The uncertainty may affect the stability and legality of the agreements.
The intricacy of contemplating crypto-backed mortgages becomes evident through factors such as the instability of cryptocurrency collateral, ambiguous regulatory environments, vulnerabilities in security, and the necessity to meticulously assess risk-reward ratios.
Furthermore, security breaches may endanger the security of the digital assets utilized as collateral. The borrower needs to entirely comprehend the terms and conditions, including the costs, interest rates, and possible tax repercussions.
People need to consider the ultimate risk-to-reward ratio when they want to determine whether acquiring a mortgage is a wise decision considering their current situation. The risk-reward ratio compares an investment’s potential profit against its possible loss.
It is determined by dividing the projected gain by the anticipated loss, and it helps investors in determining whether a business opportunity is worthy to pursue according to the ratio between prospective returns and possible risks.
