Those invested deep into cryptocurrency love collecting non-fungible tokens (NFTs) — there's no question about it. They have changed how we look at and invest in arts. However, one big problem with NFTs is that our investment is not as liquid as we would like it to be.
Once you buy your NFT, selling it is the only way to make a profit or recoup your investment. But it doesn't have to be that way anymore. NFT-backed loans are becoming a more popular way to take value out of collectibles, but is the risk worth the reward?
What is Asset-Based Lending?
We all know that the road to wealth begins with having assets. When you have assets, your wealth increases. Owning things opens the doors to other opportunities.
Picture this: you have a beautiful house, a couple of cars, and some stocks in the market. These are all part of your wealth, right? The problem comes when all your money is tied up in assets, and you have no liquidity.
This is where asset-backed loans come in to help.
Simply put, you can borrow money using your assets as collateral. Depending on the type of asset, you get a higher or lower percentage of its value in cash. This opens the doors of liquidity to a whole new level. But there's a catch: You must pay interest on the loan, usually in the form of regularly scheduled payments. And if you don't pay the loan back on time, you will lose your asset.
Can we use crypto and NFTs like this too? Yes, we can.
What are NFT-Backed Loans?
The formula is simple and does not deviate from the traditional procedure. In this case, you have a valuable NFT and need some money. We are obviously betting that our NFT will appreciate in value, and we don't want to sell it.
We can put that NFT as collateral and apply for a loan. Certain lending platforms will lend us a percentage of its value. Do you want to get your NFT back? Simply return the money and the corresponding interest to the lender.
For example: Let's say you have a Bored Ape Yacht Club NFT. Maybe you think it's a good time to invest in the market, or you have some debt to pay off. The current floor is 72.4 ETH, equivalent to about $109,000 at the time of writing.
After weighing your options, you decide to borrow $40,000. Here you are overcollateralized — that is, the value of your loan is only a fraction of your asset. Congratulations! The platform gives you your borrowed money, and your Bored Ape NFT is locked until you pay it back.
How much interest would you have to pay? Well, it depends on the platform. NFTfi, for example, allows users to list their NFT and receive offers. The borrower decides which offer is the best and accepts it.
On the other hand, BendDAO allows users to take out overcollateralized loans. Depending on how much you have borrowed and the floor price of your collection, they will give you a health factor. If your health factor reaches a shallow score, they will liquidate your NFT.
The Risks of NFT Lending
Every investment has its risk — and NFT loans are no exception. Taking a loan against an NFT may only exacerbate the inherent risks of taking a financial stake on digital tokens.
One of the most common trouble scenarios for NFT lending is the floor price falling. For example: If you borrowed against a Bored Ape Yacht Club NFT in April, the floor price back then was between 105 and 150 ETH. If you borrowed 70 ETH against it and didn't pay it back, you could be in trouble today. As of the time of writing, the floor price is at 72 ETH — which means the health of your loan is relatively low, and you run the risk of liquidation. Depending on the lender, they could liquidate your Bored Ape if you don't hurry to pay the loan and its accrued interest.
Another significant risk has to do with the dynamics of the market itself. Let's imagine a scenario where you are the lender.
Maybe you lent 20 ETH when ETH was at $2,000, and you should get back about 22.5 ETH with interest. But now ETH is at $1,500. Your value in ETH went up by 11.25%, but your $40,000 is now $33,750. It's true that you don't lose until you sell, but in the short term, it could represent a loss.
Another major concern is that the smart contracts on the lending platform may be flawed. A bad actor can hack in and steal both NFTs and tokens from the platform if the contract is faulty.
The last high-risk scenario is a cocktail for the disaster we almost saw recently: cascading liquidation.
If the price of a collection suddenly drops, it could put many of these loans in poor health. Suppose a significant number of NFTs are liquidated. In that case, this will cause the collection price to continue to fall. The more the price drops, the more liquidations will enter the market. It is like a domino effect that could cause the NFT market to fall to unimaginable levels.
Are NFT-Backed Loans for Me?
Is borrowing against your NFTs your thing? Well, it depends - there are too many factors to consider. First are the market risks, and then there are the platform risks.
If you decide that borrowing against your NFTs is right for you, congrats! You could use plenty of platforms, including NFTfi, Drops, Strip, and BendDAO.
(Ed. Note: Gokhshtein Media does not endorse any of the mentioned platforms. NFT lending can be risky, and everyone is encouraged to do their research before making any financial decisions.)
But first, make sure to do your comprehensive research on the platforms. Read their documentation from top to bottom to fully understand the subject. If what you read convinces you, go for it.
Remember one thing: every investor tolerates risk differently - invest as it suits you best.