Collateralized Crypto Loans in DeFi

Why You Can Trust Milk Road

At Milk Road we strive to help you make smarter financial decisions. While we adhere to strict editorial integrity, this post may contain references to products from our partners.

  • January 24, 2023
  • 2 Min Read

Key Takeaways

  • Collateralized loans allow you to borrow money against your crypto holdings.
  • Decentralized Finance (DeFi) protocols such as Aave and Compound enable collateralized lending in a transparent, efficient, and trustworthy way.
  • Taking out a collateralized loan can be dangerous. It’s important to understand how your collateral may be liquidated during a market downturn.

As with traditional finance, lending and borrowing play a significant role in the cryptocurrency markets. However, unlike traditional finance, where loans are provided by institutions like banks, in the crypto world loans are offered by individuals and companies.

In decentralized finance (DeFi), lending happens peer-to-peer. Any time you borrow some crypto, there is someone on the other side directly lending that crypto to you. DeFi lending protocols such as Aave facilitate loans by connecting borrowers and lenders. In order to take out a crypto loan, you must always put up some amount of collateral that is greater than the amount you are borrowing.

What is a Collateralized Loan?

Quick Sip

A collateralized loan allows you to borrow money against your crypto holdings. However, your collateral amount must be higher than the amount that you want to borrow and your collateral may get sold off to cover your loan if you do not repay it.

A collateralized loan is a loan that is secured by a collateral asset. When it comes to cryptocurrency collateralized loans, the collateral is typically other cryptocurrency assets that have a value greater than the loan amount. This ensures that if the borrower is unable to repay the loan, the lender can recoup their losses by selling the collateral. The collateral is held by the lender during the duration of the loan and is returned to the borrower once the loan is fully repaid.

For example: If you want to borrow $1,000 worth of ETH, you will be asked to deposit more than $1,000 worth of collateral for the loan (usually closer to $1,500). If you fail to repay your loan, your collateral will be liquidated in order to cover your debt.

Crypto prices are constantly changing and that means that the value of your collateral is also constantly in flux. If the value of your collateral declines significantly, you may be required to deposit more collateral, or to pay down a portion of your loan in order to avoid liquidation.

  • Useful Definitions

    Expand to learn more
    • Collateral: In order to take out a crypto loan, you will need to deposit collateral in the form of cryptocurrencies or other crypto assets. This collateral is locked up for the duration of the loan and can be liquidated if you do not pay back your loan.
    • Loan to Value (LTV): The ratio of your loan amount to the value of your collateral is known as your “loan to value” (LTV) percent. For example, if you take out a loan for $1,000 worth of ETH and you use $1,500 of ETH as your collateral, your LTV will be 66%.
    • Margin Call: If the value of your collateral declines sharply due to market moves, you may be subject to a margin call. A margin call is when your lender asks you to either deposit more collateral or pay down a portion of your loan. If you fail to heed a margin call, your collateral may be liquidated.

How Collateralized Loans Work for DeFi

Quick Sip

DeFi collateralized loans use automatic protocols to match borrowers and lenders. These protocols are faster, cheaper, and fully anonymous when compared to traditional borrowing solutions

The biggest difference between collateralized loans and traditional loans is, unsurprisingly, the collateral requirements. Beyond that, both types of loans charge interest, require regular monthly payments, and usually have a timeframe during which they have to be paid back.

Collateralized LoansTraditional Loans
APRsGenerally lowerGenerally higher
Payment TermsCan be indefiniteUsually fixed, must be paid back by a certain date
Credit Score CheckNoneRequired
Non-Repayment RisksYour collateral may be liquidatedYour accounts may be turned over to collections

DeFi loans are made through automated protocols that use smart contract technology to connect borrowers and lenders. These protocols are often open-source and are governed by a community of token holders, which makes the protocols fully transparent. These protocols are generally regarded as very trustworthy compared to centralized crypto lenders.

How to Get a Collateralized Loan in DeFi

Quick Sip

Three of the primary DeFi lending protocols are Aave, Compound, and Maker DAO. They serve similar purposes and have some overlap, but each platform provides different benefits and tradeoffs for borrowing.

When it comes to borrowing through DeFi, you’ll need to use a protocol that provides lending services. There are several large DeFi lending protocols that offer competitive lending rates.

  • Aave: Aave is one of the largest DeFi lending protocols. They support over 30 different cryptocurrencies and allow you to painlessly borrow from them. The platform offers both variable and fixed interest rates, which is a feature not commonly found on many DeFi lending platforms. Learn more about Aave by reading our full Aave review or start borrowing at Aave now.
  • Compound: Compound is another reputable decentralized lending protocol. The platform charges no trading fees, which is a huge plus compared to much of the competition. Compound can have a steeper learning curve for those new to crypto, but the benefits make it worth understanding. Learn more about Compound by reading our full Compound review or start borrowing at Compound now.
  • Maker DAO: Maker DAO is the protocol responsible for the popular DAI stablecoin cryptocurrency. A stablecoin is a cryptocurrency whose value is pegged to a fiat currency (in this case, USD). Through Maker DAO, you can borrow DAI against popular cryptocurrency assets like Ethereum, Bitcoin, Chainlink, and more.

To read more about DeFi loan protocols, check out our Borrow page.

Is a Collateralized Loan Right For You?

Quick Sip

Collateralized loans can be a great way to borrow money anonymously and at a low APR. However, you must constantly pay attention to your loan health and keep in mind that your collateral may be liquidated if you fail to repay your loan.

Collateralized loans allow you to get instant access to funds. However, they can be much more complicated than regular loans, and the collateral requirement means you can lose a lot of money if you’re not careful.

Pros

  • Just like traditional loans, collateralized crypto loans give you access to funds that you otherwise may not have.
  • Traditional loans require a series of identity verification steps and a credit score check which determines how big of a loan you can take out. Collateralized DeFi loans have no such requirements. Anyone can take out anonymous loans as long as they deposit enough collateral.
  • Due to the fact that every borrower posts collateral exceeding their loan amount, the APRs that lenders charge in DeFi are much lower.

Cons

  • Collateralized DeFi loans require collateral that exceeds the amount you are borrowing. This means that you already have to have some money in order to borrow.
  • Unlike traditional loans, which are familiar to most and are relatively straightforward, the nature of collateralized loans and DeFi as a whole can be difficult to navigate for newcomers.
  • The volatility inherent to crypto assets means that any collateral deposited for a loan may quickly depreciate. You should always be ready to deposit more collateral in case the market crashes suddenly.

Frequently Asked Questions

  • What is DeFi?

    Expand to learn more

    DeFi, or decentralized finance, is the use of crypto for peer-to-peer lending, borrowing, transacting and more.

    DeFi protocols are usually open-source, community-owned programs that facilitate DeFi transactions. DeFi is known for its increased transparency and reliability when compared to traditional finance.

  • How do you borrow using crypto as collateral?

    Expand to learn more

    Many DeFi platforms such as Aave and Compound allow you to deposit crypto as collateral and borrow against it.

  • What happens if you don’t pay back a collateralized crypto loan?

    Expand to learn more

    Crypto loans require you to deposit collateral that exceeds the value of the loan. If you fail to pay back a collateralized crypto loan, your collateral may be sold off to cover your loan amount.

  • Can you take out a crypto loan without using collateral?

    Expand to learn more

    Most crypto loans require you to deposit collateral. There are some platforms, which will allow you to take out a loan without collateral, but they have additional requirements.

Contributors

  • Avatar of George Hristov

    George is a tech writer interested in web3 startups and communities. In the dynamic world of crypto, he stays plugged in to the day-to-day headlines, deep dives, and industry commentary.

  • Avatar of Gary Anglebrandt

    Gary Anglebrandt is a US-based editor, copywriter, and communications consultant with a background in business and international news. Beyond the US, he has worked from Seoul and Beijing, and continues to work with professionals based around the globe.