How Borrowers Are Using Crypto as Collateral for Loans

Cryptocurrencies have long stopped being just a tool for buying and selling digital coins. Today, they represent an entire financial ecosystem where new ways to use your assets are constantly emerging. One of the most notable trends in recent years is crypto lending.

Simply put, a crypto loan allows you to receive money or stablecoins like USDC without selling your cryptocurrency. Instead of selling it, you use it as collateral. The principle is similar to a traditional loan secured by a house or car: the asset remains yours, but is temporarily “locked” as collateral for the lender.

Why Borrowers Use Crypto as Collateral Instead of Selling Assets

The main reason is simple: borrowers need liquidity while keeping their market position. Selling BTC or ETH ends that position at the moment of the transaction. A loan, on the other hand, allows you to access cash while the asset continues to appreciate. The key is to avoid liquidation of the collateral.

The tax aspect also matters, since digital assets are treated as property and are taxed upon sale or exchange. Simply holding assets in a wallet is not a taxable event under IRS guidance, which is why borrowers often take out loans to avoid selling when they need access to their profits. However, liquidation of collateral or repayment of the debt using appreciated cryptocurrency may still trigger tax consequences.

Types of Crypto-Backed Loans

There are two types of cryptocurrency loans: DeFi and CeFi.

Decentralized Finance (DeFi)

DeFi loans are issued through smart contracts on the blockchain — special programs that automatically execute the terms of the agreement. Banks and any other intermediaries are absent. The process is simple: you deposit cryptocurrency as collateral, the system checks the parameters, and immediately issues funds if the conditions are met. This option provides more freedom but requires a deep understanding of the technology.

Here are the key characteristics of this type:

• You manage your funds through your own wallet without involving any company that could freeze the account.
• All transactions and protocol rules are open and recorded on the blockchain, and they can be verified at any time.
• The absence of intermediaries often means lower costs.
• You need to understand wallets, network fees, and the mechanics of smart contracts, which can make the loan process more difficult for beginners.
• Errors in the code or a protocol hack can lead to loss of funds.
• There is no traditional customer support, so if you have questions, you have to rely either on yourself or on community forums.
• The interest rate may change (variable rates) in response to supply and demand, ultimately affecting the cost of the loan and the borrower’s financial stability.

Centralized Finance (CeFi)

CeFi loans are issued through centralized platforms. This is a more familiar format in which a company holds your assets and manages the loan-issuance process. It is easier to use this option, but the assets are transferred to a third party. CeFi loans have the following characteristics:

• A user-friendly interface, quick registration, and customer support make these platforms convenient for beginners.
• Large companies may implement strong security measures and sometimes offer insurance in the event of a hack.
• CeFi platforms usually operate under established rules and comply with regulatory requirements, which creates a sense of legal protection.
• The company controls clients’ assets and can restrict access to them.
• Know Your Customer (KYC) must be completed — verify your identity and provide personal information.
• Fees for convenience and infrastructure may be higher than in DeFi.

How to Get a Crypto Loan

Before taking out a loan, you need to decide on the format — whether you choose CeFi or DeFi— since their processes differ:

CeFi Lending Platform

DeFi Lending Platform

Registration and account creation on the platform.

Installation and setup of a crypto wallet with secure storage of access credentials and the seed phrase.

Identity verification.

Funding the wallet with cryptocurrency that will be used as collateral.

Transfer of cryptocurrency to the platform as collateral.

Connecting the wallet to the selected DeFi protocol.

Receiving borrowed funds in fiat or stablecoins.

Depositing the asset into a smart contract as collateral.

Receiving funds automatically — the system executes everything through code.

How Lenders Decide How Much Borrowers Can Borrow

The main inputs are collateral type, current market value, platform risk settings, and the asset being borrowed. In DeFi, those rules are written into the protocol. In CeFi, the rules appear in the product terms and the live loan interface, but the same principle applies: stronger collateral and lower-risk settings yield greater borrowing power.

A lender or protocol does not ask only, “What is your collateral worth today?” It also asks, “How hard can this asset fall before the loan becomes unsafe?” That is why borrowing capacity depends on buffers: loan-to-value (LTV), liquidation thresholds, collateral factors, and health metrics.

Borrowers can think through the decision in four steps:

1. The platform identifies whether the asset is accepted as collateral.
2. It assigns a borrowing limit based on that asset’s risk profile.
3. It applies current market prices from its pricing system or oracle.
4. It further reduces usable capacity if the product requires a larger safety margin.

Interest Rates

DeFi loans have variable interest rates, which are usually determined by the ratio of market supply and demand. Their adjustment occurs in real time. Such variability can create opportunities for lower interest payments during periods of high liquidity, but it also carries the risk of rising rates during periods of increased borrowing demand.

Main Risks for Borrowers

A loan secured by cryptocurrency can be a powerful financial tool, but it should be approached with caution. Along with the obvious advantages, there is also a downside — risks that can affect your capital.

Market Volatility and Collateral Risk

The most vulnerable part of a crypto loan is volatility. The market can turn around in a matter of hours, and the price of the asset you placed as collateral can drop sharply. When the value of the collateral falls, the safety cushion of your loan decreases as well. If the price reaches a set critical level, the platform will require you to add additional collateral. If you fail to top it up in time, the assets may be automatically sold to cover the debt. That is how the liquidation mechanism works.

Platform and Custody Risk

In crypto lending, it is important to know who holds the private keys. The SEC investor bulletin on cryptocurrency custody clearly states that whoever controls the private keys effectively controls the assets. It is also noted that hot wallets are more vulnerable to cyberattacks compared to cold wallets.

Interest Rate and Loan Terms Risk

The interest rate may be variable and depend on conditions in the lending and cryptocurrency markets. Simply put, a loan that seems inexpensive today may become significantly more expensive tomorrow. And this can happen even if you have not increased your debt.

Counterparty Risk

A crypto loan is not only about numbers and contract terms. Much depends on how reliable the lender is and how the assets are stored. It is important to understand what security measures are in place and who is responsible for safeguarding the collateral.

Smart Contract Risk

DeFi removes some of the risks associated with a centralized company, but, in turn, introduces technical risks. Everything here depends on smart contracts and, therefore, on code. If there is an error in the code, the consequences can be serious.

Sky’s documentation mentions real threats: hacker attacks, “black swan” events, pricing failures, and risks associated with new technologies. Therefore, choosing a protocol based only on the interest rate is a mistake. It is important to consider code audits, reputation, and the platform’s resilience, not just returns.

How to Compare Crypto Loan Options

When applying for a crypto-backed loan, you need to consider more than just the advertised interest rate. A lower advertised rate may actually be worse if the platform uses unreliable custody, has a strict liquidation threshold, weak customer support, or limited availability across states. The lender’s license is also important. For example, the DFPI fined crypto lending platform Nexo Capital Inc. $500,000 for violating California financial laws, including issuing loans to California residents without a valid license. You might get lucky, and the deal may go smoothly, but it’s not worth the risk.

It’s better to compare offers step by step:

• Collateral. Check out which cryptocurrencies are accepted and what the platform’s starting LTV is. Note that some platforms also offer crypto loans without collateral - a separate guide breaks down how these options work and what to expect.
• Interest. Pay attention to the APR type. Fixed rates stay the same during the life of the loan, while variable ones can fluctuate and increase over time under specific market conditions. Aim for the lowest possible APR to reduce overpayment.
• Liquidation. Liquidation LTV is the specific point at which a platform sells your crypto holdings when its price falls. Access this parameter carefully, taking into account the specific cryptocurrency you use as collateral and any predictions associated with it.
• Custody. Learn more about who controls the private keys and whether client assets are segregated from company funds. If you choose an option with a cold storage custody, make sure the lender is trusted and uses appropriate security protocols.
• Availability. Platforms must be licensed or legally allowed to operate in a specific state due to local regulations. Before proceeding, make sure the service you choose has all the appropriate documents and permits.
• Repayment. Check out the terms, due dates, monthly payments, and any other conditions associated with repayment. If you are going to pay off the loan early to save money on interest, review closely whether the lender allows it without penalties.
• Convenience. Make sure the platform is easy and straightforward for you to use. Choose a tool with a clear dashboard that shows the loan status and LTV level and sends notifications.

Tax and Legal Points Borrowers Should Know

A loan, even if secured by cryptocurrency, is generally not considered income. You are borrowing, not earning. Therefore, at the moment you receive the funds, a tax liability usually does not arise.

When it comes to interest, everything depends on the purpose of the loan. If the funds are used for investment purposes, the interest paid may, in some cases, be treated as a deductible expense. If the loan is taken for personal needs, the interest generally does not provide tax benefits.

If the collateral is sold to repay the debt, it may have tax consequences. If the cryptocurrency has increased in value since the time of purchase, there is an obligation to pay capital gains tax. The gain is calculated as the difference between the sale price and your original cost basis (plus related expenses). The tax rate depends on the holding period. An asset held for more than one year is usually taxed at the long-term capital gains rate, which is lower than the short-term rate.

The tax picture changes upon disposition. The IRS requires taxpayers to report gains and losses from digital asset sales and other dispositions, and Form 1099-DA reporting of gross proceeds from transactions began on January 1, 2025, with basis reporting on certain transactions beginning on January 1, 2026. If collateral is liquidated, or if a borrower repays with appreciated crypto in a way that creates a disposition, tax reporting may follow.