Benefits and Risks of NFT Loans

SOLARR
10 min readFeb 23, 2023

What You Need To Know When Borrowing or Lending

Key Takeaways

  • The growth of NFT lending has created new opportunities for borrowers to access funds by using their NFT as collateral.
  • NFT loans offer a number of benefits compared to traditional bank loans, from increased liquidity, easier approval process, speed and efficiency, increased transparency, lower costs, to more privacy.
  • Benefits aside, borrowers and lenders should also be aware of the risks of NFT loans including security, fraud, market volatility, smart contract risk, liquidation risk, counterparty risk, and lack of regulation.

Introduction

Non-Fungible Tokens, often known as NFTs, are gaining popularity as collectibles, investments, and even as a means of exchanging items in video games. NFTs are distinctive digital assets that signify ownership of the authenticity of a particular good or piece of content, such as works of art, music, films, and more. NFTs can be purchased, sold, and traded much like tangible collectibles since they are kept on a blockchain, which guarantees their scarcity and ownership records.

The growth of decentralized finance (DeFi) in recent years has given rise to NFT loans. But how do NFT loans work? And what are the benefits and risks, advantages and disadvantages of NFT loans for borrowers and lenders? We shall discuss specifically about these in this article.

What are NFT loans?

NFT loans are a type of decentralized secured lending that is backed by NFTs. It is a new form of lending that is quickly gaining acceptance in the digital asset community. They are similar to traditional mortgages, with the exception that you use a valuable digital asset, such as NFT, as security for the loan rather than the value of your property.

The concept behind NFT loans is simple: Borrowers can use their digital assets as collateral, which means they can now get access to funds without having to liquidate their physical or digital assets for emergency funding, which can be challenging and costly.

In our previous blog post, we have covered NFT loans in depth, including the key elements that you need to know about in NFT lending. The article serves as a good primer if you want to learn more about NFT loans. For a more general overview of decentralized lending, read this article on decentralized loans.

What are the benefits of NFT loans?

Benefits for Borrowers

NFT loans as a form of decentralized loan, offer a number of benefits compared to traditional bank loans. NFT loans give borrowers an alternative way to obtain funding that is quicker, more efficient, and convenient. Let’s explore some of the key benefits that borrowers can experience with NFT-backed loans.

  1. Increased Liquidity
    Through NFT loans, NFT owners can unlock the value of their NFTs without losing ownership of their assets. They can use their NFT as collateral against the loan. This provides a way for owners to monetize their assets quickly while still retaining ownership of their NFT. Peer-to-peer lending services offering NFT loans allow borrowers and lenders to connect directly, making it easier to access liquidity.
  2. Convenience & Easier Approval Process
    Decentralized loans using NFTs as collateral offer NFT owners the convenience of creditworthiness without having to put up physical collateral when borrowing. It can be challenging to obtain approval for conventional mortgages if you have bad credit or no credit history at all since lenders worry about your ability to repay the loan. With NFT loans, the lender does not care about your credit history. Instead, the lender uses their possession of your digital asset as security. You can be approved for an NFT loan without providing evidence of your income or credit history. All you need is your digital wallet address as proof of NFT ownership! This opens up NFT loans to a larger group of individuals, especially those who might not have access to conventional bank loans or with credit history issues.
  3. Speed and Efficiency
    Processing of an NFT loan is quick and efficient, usually taking only a few minutes. This is because NFT loan processing is automated with smart contracts and all transactions are carried out on the blockchain without the need for human interaction nor involve middlemen like banks or loan officers. When you borrow money through conventional channels, it may take weeks or even months for your application to be granted and for you to receive your funds. The speedy processing of an NFT loan through automation translates to quicker turnaround time for the borrower to access funding. NFT loans are perfect especially if the borrower needs quick access to funding for short-term purposes.
  4. Increased Transparency
    In the case of NFT loans, which are a type of decentralized loan, the terms and conditions of the loan are visible to borrowers in real-time thanks to an open, transparent platform. This enhanced openness gives borrowers more control over their loans, reduces ambiguity, and lowers the possibility of misunderstandings.
  5. Lower Costs
    Due to the decreased administrative and operational costs related to peer-to-peer lending, NFT loans have the potential to offer lower costs than conventional bank loans. This implies that borrowers can obtain loans at lower interest rates and costs.
  6. Privacy
    NFT loans provide more privacy because they don’t rely on a central entity to store and manage user data. They offer more protection for the borrowers’ privacy by not requiring them to divulge personal information to intermediaries. For those who are concerned about their privacy and do not want to provide personal information to external parties, NFT loans offer a major advantage.

Benefits for Lenders

A key component of the decentralized lending ecosystem is liquidity providers. They supply the money required for borrowers to access loans. Liquidity providers are rewarded for their funding with interest and other advantages. Let’s discuss some of the key benefits of becoming a liquidity provider in NFT loans.

  1. Passive Income
    Lenders can generate a consistent stream of passive income by providing liquidity to NFT lending platforms. This revenue is derived from the interest that borrowers pay on their loans. For those who have excess idle funds in the form of digital assets, NFT lending can be a good source of passive income.
  2. Diversification
    NFT lending offers digital asset lenders an opportunity to access an alternative asset class as a way to diversify their portfolios and reduce risk. Rather than investing their funds entirely in stocks or other ventures, NFT lending offers an additional choice for lenders.
  3. Security
    NFT lending platforms use blockchain technology to process loan transactions and protect against fraud. This lowers the risk of losses from hacking or other security breaches and ensures the safety and security of the funds provided by liquidity providers. All the terms of the loan transaction are also programmed and coded into smart contracts ensuring that terms are executed when certain conditions are met. This includes terms for handling NFT ownership transfer to the lender in the event that the borrower does not repay the loan on time.
  4. Reduced Risk in the Event of Default
    The risk of default can be decreased for lenders by using NFTs as collateral. Borrowers who miss a payment forfeit their NFTs, which are then sold to repay the loan. Lenders are able to recoup at least some of the value of the NFT asset in this way.

What are the Risks of NFT Loans?

Risks for Borrowers

NFT loans offer a lot of flexibility and advantages, but they also carry risks that borrowers should be aware of. NFT loans may be complex and risky due to volatility of NFTs, smart contract risk, liquidation risk, and a lack of regulation. Before applying for an NFT loan, borrowers should carefully weigh these risks. Borrowers can further reduce their risk by using reliable and reputable lending platforms and keeping close track of their loans and scheduled repayments. Here, we explore some of the key risks associated with NFT loans and what borrowers can do to minimize them.

  1. Volatility
    The value of NFTs have the tendency to fluctuate significantly and quickly. For borrowers using NFTs as collateral for a loan, this volatility can constitute a major risk because a sharp decline in value could trigger a margin call that would force the borrower to put up additional collateral or sell off assets to service the loan.
  2. Smart Contract Risks
    Smart contracts, which are pieces of self-executing code on the blockchain, are used to secure decentralized NFT loans. However, smart contracts do have flaws that could be used by unscrupulous parties to their advantage. Since the smart contract is responsible for managing the collateral and enforcing the loan’s terms, this risk is especially important for borrowers to consider.
  3. Liquidation Risk

NFTs are used as collateral for NFT loans, and in the instance that the value of the NFT drops, the lender might recall the loan. If the borrower is not able to service the loan margin, this may force the ownership of the pledged NFT collateral to be transferred to the lender. As a result, the borrower may lose ownership of their collateralized NFT.

4. Counterparty Risk

The lending platform may have held and locked the borrower’s collateral in escrow but the lender may default in depositing the agreed funds to be loaned. Borrowers should beware to only transact through reputable lending platforms that minimizes counterparty risk.

5. Lack of Regulation

Since the DeFi industry is currently still unregulated, borrowers may find it challenging to take legal action in the event of a disagreement or fraud. It is also more challenging for borrowers to assess the legitimacy and reliability of the lending platform due to the lack of regulation.

Risks for Lenders

Lenders in decentralized lending should also consider the risks they are exposed to after weighing the benefits of becoming a liquidity provider. Decentralized lending can be a complex and risky enterprise due to smart contract risks, counterparty concerns, and volatility. Before participating in decentralized lending, lenders should carefully examine these risks and should only participate up to what they can afford to lose. Here, we’ll explore some of the key risks that lenders should consider before participating in decentralized lending.

  1. Smart Contract Risks
    Just as borrowers are exposed to smart contract risk, lenders also face the same risk, as the smart contract is responsible for managing the collateral and enforcing the loan’s terms. It is also worthy to note that oracles are frequently used in decentralized loans to offer data like digital asset prices or ratings. These oracles may be faulty or compromised due to manipulation, resulting in the smart contract receiving inaccurate or harmful data.
  2. Counterparty Risk
    Lenders are exposed to the borrower defaulting on the loan and not repaying the loan at the agreed time, which can cause the lender to suffer losses. Since decentralized loans are operated on a peer-to-peer basis with no central governing authority, there is no centralized party to guarantee the loan.
  3. Fraud Risk
    Lenders in decentralized loans are exposed to the risk of fraud because the industry is currently unregulated, hence there is no centralized body to govern the lending activities. Malicious bad actors may often take advantage of loopholes and this lack of regulation to defraud lenders. Malicious borrowers could submit false information or use fake collateral. They could potentially also manipulate the market to artificially inflate the price of digital assets used as collateral in order to gain a higher borrowing margin. When the loan defaults, the lender would be left with a collateral that is not worth its initial artificial value.
  4. Liquidation Risk
    In NFT lending, lenders usually accept NFTs as collateral to secure the loan. If the borrower defaults on the loan and the market experiences a downturn at the same time, this may affect the value of the collateral. In this event, the lender may suffer considerable losses if the NFT collateral is sold at a loss and the lender is not able to recover the original loaned amount.
  5. Volatility
    The value of digital assets and NFTs can fluctuate drastically and quickly. Lenders may face the risk from this volatility as the value of the NFT collateral may fall below the market value when the loan was initiated. This would result in the lender potentially suffering a loss from not being able to recover the cost of the loan should it default.

How Can I Secure an NFT Loan?

Now that we’ve weighed and understood some of the benefits and risks of NFT loans, you might be interested to learn how you can secure an NFT loan. Here are the key steps to secure a decentralized NFT loan:

  1. Choose a Reputable Lending Platform
    It is crucial to pick a lending platform that is well-established and reliable in the decentralized finance (DeFi) space. Consider platforms with a track record of security and transparency as well as the level of customer support provided. Conduct thorough research by reading up reviews, visiting the community, and researching the team behind the company. A reputable platform should be transparent about its operations and clear about its fee structure.
  2. Understand the Terms of the Loan
    It is vital to properly understand all of the terms of an NFT loan before applying, including the interest rate, repayment period, and collateral specifications. Assess and verify your ability to repay the loan according to the terms set out before entering into any NFT loan agreements.
  3. Properly Store Your NFTs

In an NFT loan, your NFT will be your greatest asset that will be used as collateral to secure the loan. As such, be sure to take extra precautions to ensure the safety of your NFT asset. Use a secure wallet to store your NFTs safely. You might also use hardware wallets to give an extra level of protection by keeping your NFTs offline.

4. Use a Smart Contract for Loan Execution

In order to ensure that the loan’s terms are upheld, it is best to select a platform that uses smart contracts to manage the terms and execution of the loan, which adds a further degree of protection for both the borrower and lender.

5. Regularly Monitor Your Loan

Once you have obtained an NFT loan, it is crucial to keep track of its progress and make sure that all of its conditions are being followed. Set a reminder for loan repayment and maturity dates. The last thing you want is to risk losing your beloved NFT simply because you missed the loan repayment date!

6. Prepare a Repayment Strategy

When you take out an NFT loan, you should be mentally prepared for the worst case scenario. This entails being prepared to lose your NFT collateral. Sudden unfavorable market conditions may force you to liquidate your digital assets to repay the loan. Have a strategy in place for how to sell your NFTs and pay back the loan in case this situation arises.

Conclusion

The rise of NFT lending has opened up a new avenue for borrowers to use their NFT portfolio as collateral to access funding and secure loans while lenders are rewarded for becoming liquidity providers. While decentralized lending services such as NFT loans offer a number of benefits from increased accessibility and liquidity to speed and efficiency, they also carry risks that participants should be aware of before deciding whether or not to use them.

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