Although very popular and quickly becoming mainstream, cryptocurrency is something that still seems to confuse many people. Throw in a new financial system made up of FinTech companies that provide crypto loans and other crypto-related services. Then things start getting even more confusing, which is why all efforts to unravel this new technology are essential so everyone can make the best use of it.
One of the first questions that come to mind when someone hears or reads the term crypto loan for the first time (other than wondering what it even means) is, will it affect my credit score? This post will explore how credit scores work, how crypto lending works, and whether or not it can impact your credit score. So, read on to learn more.
An overview of credit scores
A credit score is a score or number determined by a proprietary mathematical algorithm that helps lenders predict the individual propensity to pay back loans. It is calculated by a process developed by the three major credit bureaus in the United States – Equifax, Experian, and TransUnion. These agencies use the information in your credit report to establish a score that reflects your credit risk. In other words, it’s a number that tells lenders how probable it will be for you to pay back a loan.
Conversely, it also helps financial institutions like banks and credit card companies assess the risk of lending you money. The assessment allows them to understand whether you usually make timely payments every month or are more likely to default on your payments. This, in turn, allows these companies to decide if they should give you a loan or approve you for a good credit card, to begin with — and at what rate so that they can distribute risk among their stakeholders.
Why do you need a good credit score?
A good credit score is essential because it gives you access to better terms on loans and other financial products. For example, if you want to take out a mortgage, the interest rate you’ll be offered will be influenced by your credit score. The higher your score, the lower the interest rate you’ll be offered. This can save you a lot of money over the life of your loan.
Similarly, if you want to take out a car loan, your monthly payments and the total amount you pay over the duration of the loan will be determined in part by your credit score. So a higher credit score could mean lower monthly payments and less money paid overall.
In short, having a good credit score can save you a lot of money. But a good credit score is also important because it gives you access to bigger loans. If a bank sees you as a risky investment, they’re unlikely to lend you a lot of money or any money at all. But if you have a high credit score, they see lending you money as a low-risk investment and will generally agree to give you a bigger loan.
What is a good credit score?
A credit score is a number, usually in the range of 300 to 850, with higher numbers indicating lower risk. A score of 700 or above is considered good, while an 800 or above is deemed excellent. For example, many premium credit cards require a credit score of at least 650 for you to apply, but the likelihood of being approved dramatically increases if your score is higher. Therefore, you want to aim for a score of 700 and above.
Factors that affect your credit score
Many factors go into your credit score, but the following are some of the most important:
- Your payment history: This includes whether you’ve made all your payments on time and in full. It’s one of the most critical factors in determining your credit score.
- Your credit utilization ratio: This is the total amount of money you owe compared to the available amount of credit. This factor alone makes up 30% of your credit score, and the lower your ratio, the better. The optimal credit utilization ratio is around 25%, meaning that you should avoid borrowing more than a quarter of the available credit.
- The length of your credit history: The longer you’ve had credit, the better. This shows that you’re a responsible borrower who can handle credit over a long period of time.
- The types of credit you have: A mix of different types of credit, such as revolving credit (like credit cards) and installment loans (like mortgages), is generally seen as more favorable than having only one type of credit.
- Credit inquiries and new credit: Every time you apply for new credit, an inquiry is made on your report. While this doesn’t affect your score directly, too many inquiries in a short period of time can indicate to lenders that you’re desperate for money and are, therefore, a high-risk borrower.
After considering these factors, it becomes clear that taking out any loan, including crypto loans, can impact your credit score, affecting your future ability to access more credit. So let’s take a look at crypto lending, beginning with what cryptos are and how they work.
Cryptos: What they are and how they work
Cryptocurrencies are digital or virtual tokens that we use as money or means of exchange, investments, or stores of value. Bitcoin, for example, is a cryptocurrency that we can use to buy goods and services, trade for other currencies, or hold in a digital wallet to protect savings. They work similarly to physical money because they have value because people agree that they do. However, they’re different in the sense that they’re virtual (i.e., they only exist as lines of code stored in a decentralized digital ledger known as a blockchain), they’re not controlled by any centralized government or institution, and don’t require a middle man to keep track of and verify transactions, making transaction processing cheaper, faster, safer and tamper-proof.
In the case of fiat currencies, the value is established by governments. With cryptocurrencies, there is no central authority that sets the value. Instead, the market decides the price based on supply and demand, and the way they’re set up ensures that supply slowly runs out, therefore ensuring that value will always increase. Even so, hype and trends tend to make crypto prices fluctuate wildly, making the crypto market notoriously volatile.
Crypto loans 101
Crypto loans are secured loans where you pledge a part of your crypto holdings as collateral in exchange for an equivalent amount of fiat currency or even another type of cryptocurrency. The lender holds your crypto as collateral until you repay the loan, at which point you receive it back.
For example, if you wanted to take out a 1-year, $10,000 loan with a 10% interest rate, you would put up $11,000 worth of cryptocurrency as collateral and receive $10,000 in cash. The lender would then hold onto your cryptocurrency until you repay the loan plus interest.
The pros of crypto-backed loans
Looking at the example above, you may be wondering why not just sell $10,000 worth of crypto, get your $10,000 and then use the money how you see fit, saving yourself $1,000 in interest. In other words, why even bother to use your crypto as collateral?
The answer to this is the same as with any other secured loan. However, there is a benefit to avoiding selling your assets and retaining ownership during the lifetime of the loan:
Crypto loans allow you to exchange your crypto for another currency without selling them.
One of the benefits of crypto loans is that they let you use your crypto holdings’ value without liquidating or selling your position. This appeals to people who invest in cryptos like Bitcoin or Ether as a store of value the same way they would invest in gold, letting it grow over the years.
Also, if you sell your crypto, you’ll usually have to pay income tax on the amount you earn. On the other hand, if you use them as collateral since you don’t actually sell your cryptos, receiving the loan won’t have any tax implications.
Crypto loan rates are lower than traditional loans.
Another reason to use cryptos, instead of other assets, as collateral for a loan is that interest rates for crypto loans are usually lower than for traditional loans. This can help you potentially save hundreds to thousands of dollars down the road, depending on the particular conditions of the loan.
They don’t depend on having good credit.
One of the most appealing reasons for getting a crypto-backed loan is that FinTechs usually don’t do credit checks on borrowers or rely on their credit score to approve a loan. This is because it is a secured loan, and, contrary to other secured loans, the lender won’t have any trouble at all in liquidating your collateral if you default. In addition, no significant and threatening tattooed repo men need to come knocking on your door because the loan conditions are programmed into a smart contract that will automatically change ownership of your crypto if you default.
This offers a two-fold advantage: first, you won’t add a hard or soft credit inquiry to your credit history by taking out a crypto loan. Second, you can get a loan even if you have bad credit, which probably won’t be an option in the traditional financial system.
They can be instantly approved and liquidated.
Finally, precisely because they don’t need to perform a credit check and there’s almost no need for trust when issuing a loan, lenders can approve you for a loan simply by verifying your ID and maybe doing a quick background check to make sure you’re not wanted for money laundering or something similar.
Once approved, the loan is usually liquidated right away, giving you quick access to money when you need it the most.
The cons of crypto-backed loans
Regardless of all the pros, there are some cons to look out for when considering a crypto loan.
Crypto loan repayment terms are usually short.
While, in theory, you could get a long-term loan, most crypto loans have short repayment terms of 1 to 3 years. This is because lenders want to be able to quickly liquidate your collateral if you default because of crypto price volatility.
This can make it hard to repay the loan, especially if you borrowed a large amount of money, as you’ll need to find the money to repay the loan plus interest within a relatively short time frame, which makes the next drawback even worse.
Crypto loan minimum amounts are usually high.
Most crypto lenders have a minimum loan amount that usually falls in the $5,000 to $10,000 range. This means that crypto lending is not for those looking for some extra cash to pay utility bills or buy a couple of pizzas. Combined with the fact that payment terms are usually relatively short, as stated above, this tends to make crypto loans hard to pay if you’re not careful.
You may have to provide more crypto if your collateral loses value.
When you take out a crypto loan, the value of your collateral is locked in at the time of the loan. So, if the asset’s value falls during the life of the loan, you’ll need to provide more crypto as collateral or risk defaulting on the loan and losing all your crypto. Considering the volatility of the crypto exchange market, this can be a bit too much risk to handle for most.
Will a crypto loan impact your credit score?
Now that we have a clear view of how credit scores, cryptos, and crypto loans work, we are better prepared to understand the effect of getting a crypto loan on your score.
The straight answer is that taking out a crypto loan will not generally impact your credit score.
First of all, since FinTechs that offer these services seldom do credit checks to approve your loan, requesting a loan, regardless of being approved or not, will not show up on your credit report. However, this is not always the case. TransUnion, one of the three main credit bureaus in the US, has already started allowing users to share their credit information with crypto-lending platforms, which may change in the future.
Secondly, securing a crypto-backed loan doesn’t usually appear in your credit history. Consequently, it won’t impact your total credit or your credit utilization ratio. Therefore, crypto loans are an excellent way to get liquidity for your crypto assets without losing ownership, without impacting your credit score (for good or bad), and even if you have bad credit.
The bottom line
Crypto loans have quickly become a popular way to get liquidity for your crypto assets. This is because they are quick and easy to approve, and you don’t need good credit to get one. However, there are some things you should be aware of before taking out a loan. For example, repayment terms are usually short, the minimum loan amount is high, and you may have to provide more crypto as collateral if the value of your original collateral falls.
Despite all this, a crypto loan will not impact your credit score. So if you need quick cash and don’t want to sell your crypto, a crypto loan may be the way to go. Just make sure you understand all the terms and conditions before signing on the virtual dotted line.