The idea of using digital assets as collateral against traditional loan products such as mortgages has gained traction as the value in the crypto markets has grown over recent years. They offer a way to leverage the value of a digital asset portfolio to access credit without having to liquidate the assets themselves.
How do crypto-backed mortgage loans work?
A crypto-backed mortgage agreement requires that the borrower deposits cryptocurrency as collateral into an escrow account so that it can be used to guarantee the repayment of a mortgage loan.
The first step is to find a lending company or DeFi lender that accepts cryptocurrency as collateral. Since the concept of crypto-backed mortgages is still very new, it may require some shopping around to find a reputable provider with competitive lending rates and terms.
It may be necessary to prove ownership of the digital assets to be used as security as part of the application process. In any case, the lender will determine how much can be borrowed based on the available collateral. The loan value may also consider factors such as volatility or the price of the target property. Crypto-backed loans are typically overcollateralized, which provides some mitigation against volatility risks.
To formalize the loan, the borrower will need to surrender their collateral to an escrow account and sign a contractual agreement to the loan terms. The agreement will stipulate conditions such as the interest rates, repayment terms, loan period, and what happens if the value of the collateral falls below the value of the loan.
In this scenario, the borrower may be required to add collateral to their account to bring it back to a value that sufficiently secures the loan. Alternatively, the lender may include a provision that allows them to liquidate the assets or make a legal claim on the owner’s other assets or the home itself.
If the borrower pays back the loan according to the agreement, then their collateral will be returned to them at the end of the loan term. If the borrower defaults on the repayments, then according to the loan agreement, the lender will be able to claim part or all of the collateral to cover the value of the default, and assets may be liquidated.
Depending on the lender and protocols used, blockchain and smart contracts may be used to automate the execution of loan terms.
Types of crypto-backed mortgage loans
Crypto-backed mortgage loans can be used in various scenarios where real estate financing is required:
- Home purchasing mortgages are used to fund a real estate purchase, with the loan guaranteed by the value of crypto assets.
- Refinancing, also known as remortgaging, allows an existing homeowner to provide cryptocurrencies as collateral against a loan on a property they already own.
- Bridging loans are used for interim financing when a homeowner needs to finalize the purchase of a new property for a period until the proceeds from the sale of an existing property are credited.
There are also different ways to access crypto-backed loans, depending on the lender and the products they offer. For example, some lenders may allow users to provide stablecoins as collateral, which will avoid the volatility associated with assets like BTC or ETH. It may also be possible to cross-collateralize using a variety of cryptocurrencies in a portfolio.
Lenders may use traditional lending models and infrastructure or operate as a DeFi application on a blockchain. In the latter case, the process is likely to be fully automated with little or no human involvement.
Benefits of a crypto-backed mortgage loan
There are benefits to using cryptocurrencies to secure a mortgage loan.
Access the value of assets without cashing out
Being able to leverage the value of crypto holdings without liquidating them means that the holder can benefit from any future potential upside. Furthermore, capital gains tax usually only applies at the point when the funds are cashed out, so there is no tax involved in accessing the value of the assets when they are used as collateral.
In contrast, if someone had to liquidate their crypto assets to pay for a mortgage security deposit using a traditional lender, they would incur tax liability on the transaction.
Inclusive and accessible
Crypto-backed loans may be a more accessible option for those who can’t get credit through the traditional financial system in jurisdictions where crypto-backed lending is legal. Since the loan is collateralized, it doesn’t necessarily require the borrower to have an established credit rating, which may be more accessible for a foreign investor or someone who has just arrived in a country.
Crypto-backed loan providers, particularly those operating as DeFi apps, may be quicker and easier to navigate than applying for a traditional homeowner loan.
Risks of a crypto-backed mortgage loan
Crypto-backed homeowner loans are a new concept, and as such, come with several risks of which borrowers should be aware.
Volatility
Volatility may negatively impact the value of funds to the point that they fall below the level of collateralization required by the lender. In this case, it will be necessary to top up collateral.
Funds held as collateral cannot be accessed, so they cannot be liquidated by the borrower even if the market crashes unless the borrower can repay the loan according to the agreement. If the value of the collateral drops, the loan agreement will allow the lender to liquidate the assets without any additional consent from the borrower.
Regulatory and policy hurdles
The lack of consistency regarding the legal status of cryptocurrencies may mean that there are regulatory hurdles to accessing crypto-backed mortgages in some jurisdictions.
Furthermore, it’s up to a lender to decide which crypto assets are deemed satisfactory forms of security, so it may not be possible to use all the assets in a portfolio as collateral.
Fund security
The security of funds used as collateral is also a potential risk since the borrower will need to trust the integrity of the escrow system used. Ascertaining how funds are secured, whether they are in a custodial wallet or a smart contract address, should be an important part of due diligence on any given crypto mortgage lender.
Crypto-backed mortgages essentials
- Crypto-backed mortgages allow someone to provide crypto-assets as security against the value of a mortgage loan.
- Lenders will determine the amount that can be borrowed based on the value of the assets, and funds are typically held in escrow for the duration of the loan.
- While such an arrangement unlocks some of the value in crypto assets without liquidating them, the volatility risks, regulatory hurdles, and relatively immature state of the industry mean that crypto-backed mortgages aren’t likely to be ideal for everyone.