What Is Collateralization?
Collateralization is an agreement between two parties in which one of the parties uses an asset of value to secure a loan from the other. The terms of the agreement dictate that if the borrower fails to repay the loan, the lender can get ownership over the asset and sell it to cover their loss.
Namely, this type of agreement is used by lenders that want to manage risk in fear of a loan default. However, it is beneficial to some borrowers too - there are borrowers that have a bad credit score and can’t get the terms on the loan they are looking for because of it. With collateralized loans, these debtors can get significantly better interest rates in comparison to unsecured loans.
Examples of collateralization can be seen in everyday life. The most common ones are home mortgages and car loans. Additionally, business loans are known to use collateralization to manage credit risk. All kinds of business assets such as company equipment, properties, or stocks can be used to secure a loan by the business owner.
Summary of Important Points
- Collateralization is a way of securing a loan by pledging an asset in the hands of the lender. It helps lenders reduce the risk of loan default, and borrowers with bad credit to get better interest rates.
- Overcollateralization is similar to collateralization, though it requires the pledged asset to be more valuable than the loan. It is mostly used by borrowers that want to improve their credit reports.
- Nowadays, cryptocurrency can be used as collateral to get collateralized loans from crypto exchanges and crypto lending platforms. Using crypto as collateral has some drawbacks, but can be quite beneficial in certain circumstances.
Collateralization vs. Over-Collateralization
Just like collateralization, over-collateralization is an agreement in which one of the parties offers a valuable asset to secure a loan. However, the difference is in the value of the offered asset. In some cases, the borrowers can offer an asset that is worth more than the loan they are trying to secure. When this happens, it is called over-collateralization, also known as OC.
Borrowers that decide to over-collateralize usually aim to repair their credit rating. Namely, they might get better interest rates as well, though the main purpose of OC is credit enhancement. To successfully improve a credit profile, the OC trigger should be at about 10% to 20%. In other words, the offered assets need to be higher in value than the asset-backed securities.
Can Crypto Be Used as Collateral?
Yes, it can, and it works the same way as any other collateral, like a home mortgage or a car loan. The borrower pledges their crypto assets to secure the loan they need and pays it off at the agreed terms. This kind of crypto-collateralized loan can be borrowed from a crypto exchange or a crypto lending platform. To learn more about how crypto exchanges & platforms work, consider checking out the key features of DeFi (decentralized finance).
There are some things to keep in mind when using crypto as collateral. For example, the pledged coins can not be traded or used to make purchases. Since cryptocurrency is highly volatile, it’s worth mentioning that the value of the pledged coins may deteriorate over time. If this happens, the borrower ends up paying more than they bargained for, in case the loan gets defaulted.
This is a term that economists coined as a margin call. When the decrease in value of the pledged coins reaches a certain point, the lender can decide to sell some of them to reduce the loan-to-value ratio. The amount of coins being sold is calculated using an overcollateralization ratio formula. The way a margin call works in other markets (like forex) is different when compared to how it works in crypto, so consider reading more about the differences between lending in DeFi and other markets.
On the other hand, there are a few benefits of using crypto as collateral as well. The loans that the crypto platforms offer generally have lower interest rates than credit cards or other types of personal loans. It is relatively easy to get around a 5-10% interest rate with them. There are other details that need to be taken in consideration, so understanding DeFi loans and how they work is critical to a getting a good deal.
Additionally, most crypto lending platforms don’t check credit histories or credit scores, so they are a viable option for people that have bad credit. Moreover, they offer loan amounts that match the value of the asset at 50%, or in some cases even 90% of it.
Lastly, they are working very fast and usually release the funds in a matter of hours after approval. At most crypto exchanges, borrowers can choose to get their funds in USDT (Tether) or a variety of other cryptos.
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