Does Crypto Lending Affect Your Credit Score?
Although cryptocurrency is becoming increasingly mainstream, it still confuses many people. Add to that a new financial system consisting of FinTech companies offering crypto loans and other crypto-related service. Things get even more complicated when you add in FinTech companies that offer crypto loans and other crypto-related services. This is why it is essential to make every effort to understand this new technology so everyone can benefit from it.
When someone first hears or sees the term “crypto loan”, the first thing that comes to mind (other than asking what it 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. Continue reading to find out more.
An overview of credit scores
A credit score is a number or score that is determined by a mathematical algorithm that allows lenders to predict individual propensities to repay loans. It is calculated using a process that was developed by the three largest credit bureaus in America, Equifax, Experian and TransUnion. These agencies use information from your credit report to calculate a score that reflects credit risk. It’s a number that tells lenders how likely it is for you to repay a loan.
Inversely, it helps financial institutions such as banks and credit card companies assess your risk of borrowing money. This assessment helps them understand if you are likely to make timely payments each month or default more often. 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 important because it allows you to get 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 interest rate you are offered will be lower the higher your credit score. This can help you save a lot of money over your loan’s life.
Similar to a car loan, your monthly payment and total loan amount will be affected by your credit score. A higher credit score could result in lower monthly payments and a smaller overall payment.
Having a high credit score can help you save a lot of money. A good credit score can also help you get larger loans. A bank won’t lend you much money if they consider you a risky investment. If you have a good credit score, banks will lend you more money if they consider you a low-risk investment.
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 indicates that you are a responsible borrower and can manage credit for a long 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. Although this won’t directly affect your credit score, it can indicate to lenders that there are too many inquiries within a short time period.
Considering all these factors, it is clear that any loan, even crypto loans, can have a negative impact on your credit score and affect your ability to get credit in the future. Let’s now take a look at crypto lending. Let’s start 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 function in the same way as physical money, because they have value because everyone agrees 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 set by governments. There is no central authority setting the value for cryptocurrencies. The market decides the value based on supply, demand and how they are set up. This ensures that the supply will slowly run out and that the value will continue to rise. However, crypto prices can fluctuate greatly due to hype and trends, making them notoriously volatile.
Crypto loans 101
Crypto Loans are secured loans that you use to pledge a portion of your crypto holdings in return for a similar amount of fiat currency, or another type of cryptocurrency. Your crypto is held by the lender until you repay the loan. After that, you will 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 keep your cryptocurrency until you pay 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. So, why bother using your crypto as collateral?
The answer is the same as for any secured loan. There is an advantage to not selling your assets and keeping ownership throughout the loan’s life:
Crypto loans allow you to exchange your crypto for another currency without selling them.
One of the advantages of crypto loans is that you can use your crypto holdings’ value, without having to liquidate or sell 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.
If you sell your cryptos, you will usually have to pay income taxes on the earnings. However, if you use them to secure the loan, they won’t be subject to tax since you didn’t sell your cryptos.
Crypto loan rates are lower than traditional loans.
Another reason to use cryptos as collateral for loans is that the interest rates for crypto loans tend to be lower than traditional loans. This can save you hundreds to thousands of dollars depending on the terms of your 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. Because it is a secured loan, the lender will not have any difficulty in liquidating your collateral if there is default. You won’t be contacted by any repo men with tattoos. The loan conditions are embedded in a smart contract which will change your ownership of your crypto if your default.
This offers two advantages: First, you won’t have to add a hard- or soft credit inquiry on your credit history by taking out crypto loans. 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.
Lenders can approve you for loans simply by verifying your ID, and possibly doing a background check to ensure you aren’t involved in money laundering or any other criminal activity.
Once approved, the loan can be liquidated immediately, giving you immediate access to cash when you need it most.
The cons of crypto-backed loans
Despite all the benefits, there are still some things to be aware of when you consider a crypto loan.
Crypto loan repayment terms are usually short.
While you might be able to get a long-term loan in theory, most crypto loans have a shorter repayment term of between 1 and 3 years. This is because lenders want to be in a position to quickly liquidate your collateral in the event of a default due to crypto price volatility.
This can make it difficult to repay the loan, especially when you borrowed a large sum of money. You’ll need to find the funds to repay the loan and interest in a short time, which will make 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. Crypto lending is not suitable for people looking to borrow money to pay their utility bills or purchase a few pizzas. This is combined with the fact that crypto loans are often difficult to pay due to their short payment terms.
You may have to provide more crypto if your collateral loses value.
When you take out a cryptocurrency loan, the collateral’s value is locked in at the time. If the asset’s worth falls during the loan term, you will need to provide additional crypto as collateral. Otherwise, you risk defaulting on your loan and losing all your crypto. This can be too risky for some due to the volatility of crypto exchange markets.
Will a crypto loan impact your credit score?
Now that we understand how cryptos and credit scores work, we can better understand the impact of a crypto loan on our score.
The straight answer is that a crypto loan will not affect your credit score.
First, because FinTechs offering these services rarely do credit checks to approve loans, requesting a loan will not appear on your credit report, regardless of whether it is approved or declined. This is not always true. TransUnion, one the three major credit bureaus in the US has already begun allowing users to share credit information with crypto lending platforms. This may change in future.
Secondly, securing crypto-backed loans doesn’t usually show up in your credit history. It won’t affect your total credit score or credit utilization ratio. Crypto loans are a great way to get liquidity for crypto assets without losing ownership.
The bottom line
Crypto Loans have quickly become a popular method to obtain liquidity for your crypto assets. Because they are fast and easy to approve, you don’t have to have good credit to get one. There are some things that you need to know before applying for a loan. If your original collateral is less than the value of the loan, the repayment terms are often short and the minimum loan amount is very high.
A crypto loan will not affect your credit score. A crypto loan is a good option if you need cash quickly and don’t plan to sell your crypto. Before you sign on the virtual dotted-line, make sure that you fully understand the terms and conditions.
I’m a journalist who specializes in investigative reporting and writing. I have written for the New York Times and other publications.