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The US student loan market is about $1.73 trillion, with over 42.3 million debtors owing an average of $39,351. Government has delayed federal loan repayments until January 2022, but that day is coming.
There are a lot of decentralized finance (DeFi) solutions worth learning about for students who own crypto assets and want to explore alternative loan repayment options. (This is not financial advise; conduct your own research and consult a professional before making any investment.)
What is DeFi?
Blockchain is now being used for increasingly complex financial services. DeFi is an ecosystem of decentralized applications that run on smart contracts instead of being managed by a central business.
When specific circumstances are met, smart contracts execute self-executing computer programs. Every decentralized application relies on these applications.
DeFi applications provide financial services akin to traditional bank loans, insurance, and savings accounts.
The primary distinction is that DeFi applications are open to everybody, regardless of documents, credit history, or region. People can earn income by lending, borrowing, and staking crypto assets using DeFi.
Why is a DeFi loan a good option?
These solutions are enticing because they provide lower interest rates. Borrowing rates are sometimes approaching zero.
Another reason is the availability of flexible repayment loans. DeFi loans do not require monthly payments on a certain date. You can skip a month or two without affecting your credit score.
Also, because these loans are granted through smart contracts rather than financial institutions, you do not need to have good credit to access them.
DeFi loans also allow customers to borrow against their crypto holdings, avoiding future price increases and capital gains taxes. This eliminates the need to sell crypto to pay a debt or fund a project.
Protocols typically encourage users to borrow with DeFi loans. Consider it a reward for borrowing. Unlike traditional financial systems, DeFi protocols leverage this method to draw liquidity and reward users for contributing to their ecosystems. Users are frequently compensated with governance tokens, which allow them to help manage the platform.
How may DeFi loans be utilized to pay off student debts now that you know how they work?
Peter owes a private lender $10,000 in student loan debt. Assuming Peter’s crypto ventures have earned $20,000 worth of ether, he can sell $10,000 worth of digital assets and wipe out his debt. While this seems like a good idea, it puts Jim in a bind. He sold half of his crypto holdings, reducing his position in the market. The amount he would have made if digital asset prices continued to rise has been halved. Jim must also pay a capital gain tax (CGT) when he sells his crypto holdings. In the US, the amount of CGT owed depends on the asset’s age and the taxpayer’s tax bracket.
An alternative is to put $20,000 in a DeFi loan platform as security and borrow $10,000 in stablecoins. To pay his student loan, he can exchange stablecoins for currency. Peter’s loan is in stablecoin, which means no price fluctuations. Peter can take as long as he needs to repay the DeFi loan, as long as his collateral is worth enough to avoid liquidation. This method relieves the monthly repayment pressure.
Stablecoins are digital assets backed by fiat currencies. These assets are usually pegged 1:1 to a fiat currency. USDT, for example, has a 1:1 link with the US dollar, meaning that if you own 30 USDT tokens, their value will be about $30.
Peter’s debt hasn’t vanished. Instead, he moved his debt to a decentralized environment where he has more control over repayment. Plus, the governance tokens or incentives can be sold to pay off some of the debt. For example, AAVE rewards USDT borrowers with 1.66 percent APR paid in staked AAVE tokens. A USDT loan now has a 3.88 percent interest rate. As a result, a borrower can utilize earnings to pay down some debt.
Similarly, Peter’s DeFi loan will be smaller as the value of the digital asset used as collateral increases. To properly grasp this potential, we must examine the LTV statistic and its influence on DeFi borrowers.
What is LTV?
LTV measures the size of your loan compared to your collateral. LTV is the loan-to-value ratio. In this case, Peter has borrowed 50% of his collateral. His LTV is 50%. The LTV would have been 75% if he had borrowed $5,000. To eliminate counter-party risks, certain protocols allow users to borrow above 50% of their collateral.
The borrower’s LTV is bound to fluctuate over the loan term, especially if the collateral is in volatile cryptocurrencies. So, if Peter puts up 5 ETH at $4,000 each as collateral, the LTV automatically decreases if the price of ETH rises to $6,000 in two months. Let’s perform the arithmetic to prove that.
ETH price = $4,000
5 ETH deposited
Collateral value = $20,000
$10,000 loan size
LTV = 50%
End-of-year ETH price = $6,000
End-of-year collateral value = $6000 * 5 = $30,000.
LTV at year’s end = $30,000 * 100% = 33.3
In summary, Peter’s LTV dropped from 50% to 33.33% due to ETH price increases. Note that this example assumes Peter has not made any payments. But, just as cryptocurrency volatility may diminish the debt’s value, it may also increase the chance of liquidation (more on this later).
DeFi rates
AAVE, Maker, and Compound all provide variable-rate loans. Demand for the digital item in issue influences the rates. You can also get fixed rate DeFi loans depending on the protocol, but they cost more.
30 day Compound and AAVE average rates range from 0.01 percent to 5.12 percent. Rates range from 2.79 to 28.06 percent on Compound and from 0.04 to 168.98 percent on Aave. No information on Maker.
There are alternative solutions that do not use any borrowing rates at all. The borrower just pays back the borrowed amount. Liquity is one DeFi option that offers interest-free borrowing.
Repaid loans
Another element that distinguishes DeFi loans is self-repaying loans. We’ve already proven that placing digital assets as collateral can pay back a portion of the loans. Some protocols go a step farther by including interest-generating mechanisms for self-repayment.
The protocol uses the collateral to fund other protocols’ yield farming enterprises. The protocol then deposits the collateral on other DeFi sites to earn interest. The proceeds are then utilized to pay down the loan over time. In other words, the prospective money earned by using your collateral will eventually pay off the loan. Alchemix is an example of such a platform.
What are the dangers of DeFi loans?
Given that DeFi is a new concept, it is not surprising that it has hazards. Consider the following before choosing DeFi to repay your student loan.
Liquidation
These DeFi platforms include liquidity thresholds – the LTV at which the protocol sells collaterals to settle obligations. Assume that Peter borrows $10,000 at 50% LTV, and that the liquidation threshold is set at 75% LTV. Even if the price of ETH decreases dramatically, Peter must keep his loan value below 34% of the total value of his collateral.
Variable Rates
DeFi lending protocols frequently offer variable rates based on demand and supply of digital assets. DeFi loans become costly when the APR rises. The lack of steady interest rates makes it impossible to predict how long it will take to repay loans.
Smart Contracts
Smart contracts power DeFi protocols, automating loan-borrowing operations. Notably, the smart contracts’ underlying code is authored by people. Thus, it is hard to rule out the possibility of errors that endanger consumers’ digital assets. Bugs expose smart contract-based protocols to security and systemic threats.
Before using DeFi techniques to pay off your student loans, as with other crypto-related possibility, do your homework. While DeFi loans are a terrific method to avoid traditional lender debt, they also expose borrowers to risk.
