How to pay off student debts is a thought that practically no college student or recent graduate wants to entertain.
In addition to paying for food, gas, rent, and other miscellaneous expenses, you will have to pay a boatload of student loan debt when you graduate, along with your snazzy new degree.
How Do DeFi Loans Work?
By extending the usage of blockchain beyond straightforward value transfers, DeFi enables more intricate financial services. DeFi refers explicitly to an ecosystem of independent, decentralized applications running smart contracts rather than relying on a central organization to administer them.
Computer programs known as smart contracts execute independently and carry out specific tasks when certain criteria are met. Every decentralized application is built on top of these programs.
Loans, insurance, and savings accounts are just a few of the financial services DeFi applications provide comparable to those offered by conventional institutions.
The primary distinction is that DeFi programs make these services accessible to anyone, regardless of their identification, credit history, or location. People can access secured and unsecured loans through DeFi and lend, borrow, and stake crypto assets to earn income.
What makes a DeFi loan a practical loan repayment choice?
These solutions’ better interest rates are what the first appeal to people about them. The borrowing rates are occasionally relatively low.
Access to loans with flexible repayment terms is another consideration. You are not required to make payments on a particular day every month when you take out DeFi loans. You can choose to skip a month or two without being concerned about the harm it will do to your credit score.
More importantly, you do not need to maintain a solid credit score to receive these loans because they are granted via smart contracts rather than banking institutions.
DeFi loans also allow customers to borrow money against their crypto holdings to avoid missing out on future profitable market moves and to avoid paying capital gains taxes on sold digital assets. You won’t have to sell your crypto holdings to settle the debt or raise money for a project.
DeFi loans have another essential distinction: users are frequently encouraged to borrow via the protocols. Consider it as compensation for taking out a loan. Although this method is unrelated to the conventional financial system, DeFi protocols frequently employ it to draw liquidity and compensate users for their ecosystem contributions. Users are typically rewarded with governance tokens, which users can use to help manage the protocol’s daily operations.
How does DeFi work in terms of student loan repayment?
Consider that you want to pay off a $12,000 student loan. Let’s also imagine you have worked in the cryptocurrency sector for a while and amassed ETH worth $20,000.
You may sell $12,000 of digital goods and immediately pay off the entire loan. Although it might seem like the proper course of action, this approach has certain drawbacks.
You have effectively decreased your position in the crypto market by selling 60% of your cryptocurrency portfolio. As a result, if the cryptocurrency market prices rose again, you would earn much less money from it. You must pay capital gains tax every time you sell your cryptocurrency assets for fiat currency.
You’re not required to follow that route because of DeFi. Another choice is to use your $20,000 worth of ETH to secure a loan worth $12,000 in stablecoins by depositing it in a DeFi lending mechanism as collateral. Afterward, you can exchange the stablecoins for fiat money to pay off the outstanding obligation. You won’t experience any price volatility because your loan is likely issued in the same currency as your stablecoins.
You can take your time paying back the DeFi loan because there is no set repayment date as long as your collateral is still valuable enough to prevent the risk of liquidation. Please continue to keep an eye on this.
Due to the volatility of crypto assets, you must maintain a sufficient level of over-collateralization. If you find yourself getting near the liquidation level, you can reduce part of your debt or add more crypto assets to strengthen your position as collateral.
Nevertheless, you can pay off your debt at your speed right now. The ability to sell interest or governance tokens to pay off a portion of the debt is also crucial. Contrary to popular belief, the quantity of the crypto loan will shrink should the value of the cryptocurrency asset used as collateral increase.
Loan rates for DeFi
You can acquire loans with variable interest rates on websites like Aave, Maker, and Compound. The demand for relevant digital assets is one of many variables influencing the rates. You can also borrow money using DeFi protocols with fixed rates. However, the costs are higher depending on the protocol being utilized.
On Compound, the average interest rate for a 30-day loan is 0.01%; on Aave, it is 0.01%–5.89%. The borrowing rates for Compound range from 2.79% to 28.06%, while Aave ranges from 0.04% to 168.98%. There wasn’t any information on Maker.
It is also important to note that choices are available without using any loan rates. In this case, the borrower must pay back the borrowed amount. Liquidity is a prime illustration of a DeFi solution that provides loans with no interest.
Dangers associated with DeFi loans
Given that the DeFi loan is a new idea, it is not surprising that there are risks associated with it. Before deciding to pay back your student loans via DeFi, be sure to take the following factors into account.
Issues with smart contracts
Smart contracts, which simplify the procedures associated with borrowing loans, are what power DeFi protocols. It is important to note that humans wrote the underlying programming for these smart contracts. Therefore, it is hard to discount the probability of running into mistakes that could endanger the security of users’ digital assets. We have often seen how defects put smart contract-based systems at risk for systemic and security flaws.
Before attempting to employ DeFi techniques to pay off your student loan, as with other crypto-related possibilities, it is essential to conduct your study. DeFi loans are a fantastic method to relieve debt stress to traditional lenders, but this strategy also exposes borrowers to hazards.
Variable rates
DeFi loan protocols frequently offer variable rates since the annual percentage rate (APR) varies according to the availability and demand of loans for digital assets. DeFi loans become costly in certain circumstances where the APR rises. Since interest rates are not steady, predicting how long borrowers will take to repay loans is challenging if they choose self-repaying loans or other reward-generating strategies.
Liquidation
DeFi lending protocols contain liquidation criteria, and when they are reached, the protocol sells the collateral to pay off a borrower’s obligation. Using the MakerDAO example, if the price of ETH drops below $150, you will be charged a 13% liquidation penalty. This is because the minimum collateralization ratio is 150%, and your collateral is $150 worth of ETH for a loan of $100 in Dai.
Final Thoughts
As previously noted, you can now forego the penalty by paying back a portion of your loan in Dai or by adding more collateral. The system will continuously sell the collateral to pay off the loan if you don’t do one of the two things, and the price of ETH keeps falling.