What is Loan-to-Value Ratio and How Does it Work?
Many crypto lending platforms not only provide opportunities for users to take out crypto loans but also present attractive investment options, such as interest accounts and crypto savings accounts.
These investment avenues allow users to earn interest on several crypto assets.
Unlike traditional banks that typically require credit checks for personal and traditional loans, most crypto lending platforms approve crypto loans without scrutinizing borrowers’ credit histories. This unique feature has allowed crypto traders and investors to access instant personal loans.
While obtaining a loan through crypto lending platforms is generally straightforward, borrowers are required to provide collateral to secure a crypto loan. Moreover, these platforms assess the Loan-to-Value ratio (LTV) before approving loans for users.
But what is Loan-to-Value ratio?
This article explores what you need to know about loan-to-value ratio and its relevance in the crypto lending industry.
What is Loan-to-Value Ratio (LTV)?
Loan-to-value (LTV) ratio refers to the ratio comparing the amount of your loan to the value of the collateral you provide. It’s commonly used by financial institutions to assess the risk involved before approving a loan.
Loans with higher LTV ratios are generally seen as riskier, leading to higher interest rates if approved. Lower LTV ratios, on the other hand, increase the likelihood of loan approval and often result in lower interest rates.
Traditional financial institutions rely on LTV to determine the risk associated with lending money. This assessment helps differentiate between high-risk and low-risk loans.
Banks, in addition to LTV assessments, use third-party financial platforms to review the credit history of borrowers. These platforms collaborate with credit agencies to determine the credit score of each borrower.
This process helps to determine the creditworthiness of potential borrowers, as a higher credit score indicates a lower risk for the lender.
On the other hand, many crypto lending platforms skip background checks on users. Therefore, when granting a crypto-secured loan, these platforms give considerable attention to the loan-to-value ratio.
How to Calculate Loan-to-Value Ratio in Crypto
Many cryptocurrency lending platforms do not conduct credit checks on their users. Instead, they ask users to provide cryptocurrency assets as collateral to secure crypto loans.
As a result, they assess the risk of lending by using the loan-to-value ratio.
A mathematical formula can be used to calculate the LTV for a crypto loan. This involves dividing the loan amount by the value of the collateral and expressing the result as a percentage.
The mathematical expression of the formula is shown below:
(Loan amount / Value of collateral) X 100%
For instance:
Loan amount: $15,000
Value of collateral: $45,000
Loan-to-Value ratio = ($15,000 / $45,000) X 100% = 50.0%
In this example, the LTV of this loan is 33.3%
How Crypto Volatility Affects Loan-to-Value Ratio
Except stablecoins, most cryptocurrencies, including Bitcoin, Ether, Litecoin, Solana, Dogecoin, and Bitcoin Cash, tend to experience significant price fluctuations.
Borrowers should closely monitor the worth of their collateral in case there is a significant decline in the value of cryptocurrencies.
During a crash in price, the value of crypto deposits used as collateral diminishes. Consequently, the LTV ratio of a loan, which uses a crypto asset with a fluctuating value as collateral, increases. Borrowers must vigilantly check their accounts during such periods to prevent the forced sale of their collateral.
Before initiating a margin call, crypto lending platforms like Nexo usually send alerts via SMS and email to borrowers, urging them to repay their loans or add more crypto assets as collateral. This precautionary measure prevents the liquidation of crypto loans due to the decline in the value of cryptocurrencies.
Failure to repay existing loans or supplement collateral with additional crypto assets may prompt the crypto lending platform to sell the collateralized asset to settle the loan. Certain platforms, such as Binance loans, may also impose a 2% fee on the original loan amount in case there is a forced liquidation.
Adjusting the Loan-to-Value ratio is a prudent strategy to minimize the risk of forced selling, especially during periods of significant price fluctuations. It is, therefore, recommended to closely monitor and make necessary adjustments to the LTV when the prices of cryptocurrencies exhibit significant volatility.
Conclusion
Traders can borrow BTC, ETH, and other significant cryptocurrencies to participate in futures or margin trading. Nevertheless, these approaches have their risks, necessitating traders to consistently conduct thorough research to minimize the likelihood of substantial losses.
Although it’s not easy to forecast market movements, you can safeguard against liquidation when borrowing crypto by consistently monitoring and adjusting your Loan-to-Value (LTV) ratio.
Learn more about Loan-to-Value ratio and its role in DeFi:
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