What Are NFT Loans and How Do They Work?

TL;DR

• NFT loans are a type of loan in the crypto space where NFTs are used as collateral. 

• The concept of NFT loans brings decentralized finance (DeFi) into the world of digital arts, collectibles, virtual real estate, and other unique tokenized assets.

• Key metrics to consider when looking at NFT loans include loan-to-value (LTV), liquidation ratio, and NFT floor price.   

• NFT loans offer great benefits to unlock liquidity and access borrowing instantly for NFT owners but also come with risks, including price volatility, lack of liquidity, and potential regulatory risks. 

What Are NFTs? 

An NFT, or Non-Fungible Token, is a cryptographic token hosted on a blockchain that is used to represent a digital asset. Unlike cryptocurrencies like Bitcoin or Ethereum, which are fungible and identical to each other, NFTs are unique and "non-fungible". Each NFT has different properties and values.

NFTs generally represent ownership of one-of-a-kind items such as artwork, video game characters and skins, trading cards, virtual real estate, and other digital goods. This means non-fungible items cannot be traded on a standardized scale as their value is derived from their uniqueness and the subjective value that buyers place on them.

NFTs are increasingly gaining mainstream adoption, as creators use them to monetize their digital creations, collectors utilize NFTs to own unique digital assets, and brands leverage them to build closer relationships with their customers. 

What Are NFT Loans? 

NFT loans, as the name suggests, are a type of loan in the crypto space where NFTs are used as collateral. Traditionally in the DeFi space, fungible tokens such as bitcoin and ether have been used as collateral to secure loans. But with the increasing value and popularity of NFTs, platforms are offering NFT holders the opportunity to use their assets as collateral for loans. 

Some of the most valuable NFT collections boast single items valued at tens of thousands of dollars. NFT loans allow owners of NFTs to obtain liquidity conveniently without having to sell their NFTs. The concept of NFT loans brings DeFi into the world of digital arts, collectibles, virtual real estate, and other unique tokenized assets.

How Do NFT Loans Work? 

NFT loans work similarly to crypto loans. Here's a simplified example of how an NFT loan works: 

Step 1: Users request a loan

An NFT owner uses their NFT as collateral and requests a loan on a lending platform that supports NFT loans.

Step 2: NFT appraisal 

The platform, or other users on the platform, assess the value of the NFT. It’s easier to do this if the NFT has a stable secondary market price history, but can be challenging for less-established NFTs, given the uniqueness of each NFT and the often subjective nature of their value.

Step 3: Loan issuance 

Once the NFT’s value is agreed upon, the lender provides a loan to the NFT owner, typically issued in a stablecoin. The NFT is then locked in a smart contract until the loan is repaid. The smart contract generally specifies the loan’s terms, including the desired amount, duration, and interest rate. 

Step 4: Loan repayment

Once the borrower repays the loan, the NFT will be unlocked and returned to the borrower. But if the borrower fails to repay the loan, the NFT is automatically transferred to the lender by the smart contract. This process is referred to as liquidation. 

Users can find platforms that offer NFT loans by checking the platform’s product pages or by researching various DeFi DApps. It’s best to do thorough research to find a platform with the best loan terms, solid reputation, and track record if you are thinking about getting an NFT loan.  

Key Metrics to Understand About NFT Loans

Using your NFT as collateral to obtain a loan is a process that requires an in-depth understanding of the key metrics that measure the viability of the loan.  While these terms are similar to the ones used for crypto loans, they’re designed to account for the added complexity that comes with using NFTs as collateral. 

1. Interest rate 

When you take out a loan using NFTs as collateral, you need to pay attention to the interest rate you pay. Understand how much interest you pay over the duration of the loan. Also, understand the difference between APR and APY. 

2. Loan-to-Value (LTV) ratio   

The loan-to-value (LTV) is the ratio of the loan amount to the value of the collateral. For example, if you borrow 50 DAI using an NFT worth 100 DAI as collateral, the LTV ratio would be 50%. This ratio is an essential risk metric for lenders, as it helps gauge the risk of the loan becoming under-collateralized if the value of the collateral (the NFT) drops.

The maximum LTV ratio that a platform allows varies, but in many cases, it's between 50% and 75%. For more volatile assets, the maximum LTV ratio tends to be lower to account for price fluctuations. The LTV ratios for NFT loans are often lower than that of crypto loans due to their higher price volatility and the challenges in accurately appraising their value.

3. Liquidation ratio 

This ratio is the LTV ratio at which the collateral can be liquidated to repay the loan. If a borrower's LTV ratio reaches the liquidation ratio, their collateral can be sold off by the platform to ensure the loan is repaid. In NFT loans, the lender could claim ownership of the NFT. 

For instance, if a platform has a liquidation ratio of 75%, and a user's LTV reaches this level due to a drop in collateral value, their collateral may be liquidated. Often, a penalty fee is also applied in these scenarios, which provides an incentive for borrowers to avoid liquidation.

Borrowers need to pay close attention to this metric as liquidation will result in the loss of their NFT.

4. NFT floor price 

The floor price of an NFT refers to the lowest-priced item listed within a collection and is considered one of the main metrics used by collectors to measure and evaluate a project’s desirability. It gives buyers an idea of the minimum investment required to own an NFT from a particular project. 

Floor prices can influence the terms of a loan, even if the NFT used as collateral possesses much rarer traits than the cheapest NFT in the collection. A collection's floor price can have a significant impact on borrowing limits and LTV ratios. For instance, a borrower who wants to use an NFT with unique and rare attributes as collateral might expect to receive a higher loan amount, while more common NFTs might get a smaller loan amount.

These ratios are crucial to understanding the dynamics of collateralized loans in DeFi and can vary widely depending on the platform and type of collateral. As NFT-backed loans are still a relatively new and evolving space, these ratios could differ considerably from those typically seen with fungible token collateral. The relatively illiquid nature of NFTs and the difficulty in appraising their value can also impact these ratios.

The Benefits of NFT Loans

NFT loans offer numerous benefits, including the following: 

1. Unlocking liquidity 

Owners of high-value NFTs can unlock liquidity without selling their assets. This can be beneficial for those who believe in the long-term value of their NFTs but need immediate access to funds. 

2. Expanding DeFi to the digital art space 

NFT loans provide an avenue for NFT holders to participate in DeFi by taking out loans. This could be particularly beneficial for artists or collectors in the NFT space who want to leverage their digital assets in DeFi.

3. No credit checks 

As with other DeFi loans, NFT-backed loans don’t require credit checks. This is a significant advantage for individuals with low credit scores or those who don’t have access to traditional banking services.

The Risks of NFT Loans

It's important to note that NFT loans come with risks. The value of NFTs can be extremely volatile and can be difficult to accurately appraise. NFTs are less liquid than traditional cryptocurrencies, which means if a borrower defaults, the lender could have difficulty selling the NFT to recoup their funds.

The risks of NFT loans that one needs to consider include the following: 

1. Price volatility 

The value of NFTs can be highly volatile, making it difficult to accurately appraise their value for loan collateral purposes. This could lead to situations where an NFT's value drops below the loan value, leading to liquidation.

2. Lack of liquidity 

NFTs are often less liquid than other crypto assets. If a borrower defaults on their loan, the lender might have trouble selling the NFT to recover their funds.

3. Smart contract risk 

NFT loans, like other DeFi protocols, are typically governed by smart contracts. These contracts can have bugs or vulnerabilities that hackers can exploit, leading to the loss of funds or NFTs. 

4. Regulatory risk 

As with other areas of DeFi, there's regulatory uncertainty surrounding NFT loans. Future regulations could impact the viability of NFT loans or introduce additional compliance requirements.

Closing Thoughts 

NFTs have gained popularity as they tokenize a range of assets, from digital art to real estate. NFT loans represent an exciting evolution in DeFi, offering liquidity options for holders of unique digital assets. 

While NFT loans offer a new way for NFT owners to unlock liquidity from their assets, they come with significant risks. It's important for users to fully understand these risks before engaging with NFT loans or any other DeFi protocols.

Disclaimer and Risk Warning: This content is presented to you on an “as is” basis for general information and educational purposes only, without representation or warranty of any kind. It should not be construed as financial, legal or other professional advice, nor is it intended to recommend the purchase of any specific product or service. You should seek your own advice from appropriate professional advisors. Where the article is contributed by a third party contributor, please note that those views expressed belong to the third party contributor, and do not necessarily reflect those of Hibt Academy.