What is Collateralized Lending? A Basic Overview for Crypto Loans

If you want to borrow money, the lender needs assurance that they will get their money back if you can't make payments.

Collateral serves as this assurance.

In this blog post we will dive into what collateralized lending is and the best practices for both borrowers and lenders in crypto and traditional finance.

What is Collateralized Lending?

Collateralized lending is a type of lending where the borrower pledges an asset as collateral to secure a loan. This means that if the borrower is unable to repay the loan, the lender can seize the collateral to recover the debt. Collateralized lending is commonly used in real estate, auto, and personal loans to reduce the risk for the lender. 

In the unfortunate incident in which a borrower defaults on a loan, the lender then takes ownership of the asset used to secure the loan and can sell it to cover the loss.

Collateralized loans increase the chances of a loan approval, especially for people with less than stellar credit, because the lender is inheriting less risk. 

Thanks to the rise of decentralized finance, collateralized lending has also made its way into the cryptocurrency space, where digital assets can serve as collateral for the loan.

In crypto collateralized lending, a borrower’s credit score does not generally come into play.

Instead, crypto lending platforms rely on the blockchain and smart contracts to ensure they can take possession of the secured assets if the borrower defaults on the loan.

In this case, there is no bank or other third-party needed thanks to the decentralized nature of the blockchain. 

Collateralized Lending Types 

Fortunately there is no shortage of options when it comes to collateralized lending.

Borrowers have the choice to use a plethora of ways in which to access this feature, whether it’s through a personal loan, small business loan, real estate loan, car loan, or crypto loan for that matter.

The wide-scale availability of collateral-based lending should give borrowers some assurance that this is a popular product.There are nuances that are attached to every type, such as: 

• Personal Loan: The beauty of a personal loan is that the use cases by which the borrower can direct the assets are broad in scope. Use the funds to pay for medical expenses, consolidate credit card debt, or make renovations on a home. In this case, the borrower can back the loan with a house, car, cash from a savings account, investments, jewelry or fine art, for example. A personal loan can also be backed by future compensation, though this option introduces greater risk.

• Small Business Loan: A business loan is similar to a personal loan in that it can be secured by assets such as property, vehicle, or savings but also assets that are unique to entrepreneurs such as equipment, inventory, or accounts receivable, for example. 

• Real Estate Loan: In this case, the collateral for a real estate loan is the underlying property that is being purchased. Should the borrower neglect to make payments on the mortgage loan, the lender can take ownership of the property. The lender will have the property appraised first to ensure that its value is sufficient to cover the size of the loan in the event of a foreclosure. 

• Car Loan: Once again, the asset that is being purchased, in this case a vehicle, is used as collateral for the underlying loan. The vehicle can be repossessed in the event that the borrower fails to make payments. And once again, the lender will have the property appraised first to ensure that its value is sufficient to cover the size of the loan in the event of a default.  
• Crypto Loan: When it comes to a secured crypto loan, the borrower uses other digital assets as collateral for the loan. In this case, the lender holds onto the crypto assets to secure the loan and at the end of the loan term will return the crypto assets to the borrower. If the borrower defaults on the loan, the crypto lender takes possession of the crypto assets used to secure the loan to cover any losses they may incur. 

What is Collateralized Investing on Margin?

In a riskier bet, the emergence of collateralized investing on margin has upped the ante.

However, it places the borrower in a much more vulnerable position should things not turn out the way they had hoped. 

Margin investing is a strategy in which the lender holds more of the cards and the borrower is making a risky bet.

It involves using securities or currency that the broker has allowed the investor to buy using borrowed funds as collateral.

Similar to traditional finance, this practice has also made its way to the crypto lending market, allowing investors to make trades with borrowed funds used as collateral for the loan.

The amount of the collateral is expressed as a percentage of the loan. 

If all goes well, the investor uses the profit they’ve earned from the buy to repay the loan.

However, in the event that the crypto prices go down, the broker then has the control to implement a margin call, at which time the borrower must either bolster their collateral or close the position and pay the loan back.

In this case, the borrower has everything to lose while the lender is sitting pretty. 

What Factors Affect Interest Rates?

Central banks like the U.S. Federal Reserve sets the short-term borrowing rates that banks charge one another for the overnight lending and borrowing of reserves. This rate eventually makes its way into other loan products in the economy, affecting everything from credit card rates to car financing to personal loans and beyond. 

Considering that collateralized loans soften the risk for lenders, borrowers can generally expect a more attractive annual percentage rate (APR), expressed as a percentage of the loan, than they would otherwise receive. A lower interest rate is one of the key advantages to collateral-based lending, as it can add up to significant savings for the borrower over the loan term, up to thousands of dollars in some cases. 

Even just a moderately lower percentage on a loan’s interest rate can go a long way. However, some loans are more conducive to others for lower interest rates, while for other products such as mortgage loans or auto loans they can be more difficult to come by.

Interest rates can be affected by various factors, starting with the supply/demand dynamics surrounding the type of asset being borrowed. For example, an asset in which demand is high and supply is on the low side could have a higher interest rate attached for the borrower. In addition, the borrower’s credit profile can come into play when determining the interest rate, whereas the higher the risk, the higher the interest rate and vice versa. Considering that collateral-based loans give the lender some recourse, the lower risk can be reflected in a lower interest rate. 

Undercollateralized Crypto Lending

Not all collateralized loans are the same. An undercollateralized loan is one in which the value of the collateral is not sufficient to offset any losses for the lender should the borrower default.

In the case of undercollateralized loans, the collateral ratio would be less than 1:1.

A couple of blockchain projects are case studies in what can go wrong with undercollateralized or uncollateralized crypto lending as well as the ripple effect this can have on the broader cryptocurrency market.  

• Celsius: Celsius is one example of a crypto platform in which lenders did not always protect loans with assets. Celsius was forced to file for bankruptcy protection after it faced a perfect storm of a crypto winter, risky bitcoin trades that went south, and liabilities that surpassed its assets. Celsius has over 100,000 creditors, a number of which lent to the institution without requiring any collateral to secure the loans.
• TerraLuna: The collapse of Luna and it's stablecoin, UST, was a direct result of lack of sufficient collateral underlying the debt. UST was minted into existence using Luna as collateral. Eventually, the value of Luna became 10x smaller than the value of the stablecoin, which led to its downfall.

To everyone who deposited UST into Anchor protocol and/or used LUNA as collateral. Stay strong. Talk to people. Let your emotions out. At the end of the day it’s money that we can earn. But a life can’t be replaced. #terraluna #ust

— Max (@magikkwave) May 11, 2022

Overcollateralized Crypto Lending

With overcollateralized crypto lending, the risk pendulum swings in the opposite direction to safety and security. In this case, the size of the collateral surpasses that of the loan, thereby protecting the lender from losses in the event of a default. There are a handful of key players in this market, including:  

• Liquid Loans: Liquid Loans is a decentralized lending protocol built on the PulseChain, a fork of the Ethereum blockchain known for its lower fees and speedy transactions. It’s designed to give holders of the PulseChain (PLS) coin a way to unlock value from their holdings without having to sell their crypto in the market. As users lock up their PLS in smart contracts, they mint USDL coins, through which they can take a 0% interest-free loan against their holdings on a timeless repayment term. The two native tokens of the Liquid Loans protocol are USDL, an algorithmic stablecoin that targets a value of 1 USD despite not being pegged to any fiat money, and LOAN.
• Liquity: Liquity is a decentralized interest-free lending platform on the Ethereum blockchain. It allows users to borrow LUSD against ETH at a 0% interest rate and a 110% collateral ratio, fueled by the LUSD stablecoin. Loans are paid in ETH-backed LUSD through which users can borrow up to 90% of the value of their ETH holdings, and loans can be repaid at any time.