The student loan debt market in the United States stands at more than $1.73 trillion, with over 42.3 million debtors required to pay an average debt of $39,351 each. For now, the government has put federal loan repayments on pause until January 2022, but that deadline is fast approaching.
For students who hold crypto assets and are interested in exploring different avenues for repaying their loans, there are a number of decentralized finance (DeFi) options worth knowing – though they should be aware of the risks. (This article is for educational purposes only and not financial advice; do your own research and consult a professional before making any kind of investment.)
What is DeFi?
DeFi expands the use of blockchain from simple value transfer to more complex financial services. Specifically, DeFi refers to an ecosystem of decentralized applications – autonomous applications that operate using smart contracts instead of relying on an underlying company to manage them.
Smart contracts are self-executing computer programs that perform certain functions when conditions are met. These programs lie at the heart of every decentralized application.
DeFi applications offer a range of financial services similar to the loans, insurance and savings accounts offered by traditional institutions.
The main difference is DeFi applications allow anyone to access these services, regardless of a person’s documentation, credit history or geography. Through DeFi, people have the ability to access collateralized and uncollateralized loans, and earn interest by lending, borrowing and staking crypto assets.
Why is a DeFi loan a viable loan repayment option?
The first thing that makes these solutions appealing is that they offer better interest rates. In some cases, the borrowing rates are near zero.
Another factor is the possibility of accessing loans with a flexible repayment period. When taking DeFi loans, you do not need to make payments on a specific date each month. You can decide to skip a month or two without worrying about the damage it will have on your credit score.
Even more important, because these loans are issued via smart contracts and not by financial institutions you do not need to maintain a good credit score to access these loans.
DeFi loans also allow users to take loans against their crypto holdings to avoid missing out on potential bullish price movements and avoid paying capital gain taxes on sold digital assets. This removes the need to sell your crypto holdings to settle a debt or finance a project.
Another key difference about DeFi loans is that protocols often incentivize users to borrow. Think of it as being paid for taking out a loan. While this system is alien to the traditional financial system, it is a common strategy used by DeFi protocols to attract liquidity and reward users for contributing to their ecosystems. Users are usually rewarded with governance tokens, which allow participants to contribute to the day-to-day running of the protocol.
Now that you understand what makes DeFi loans tick, how can they be used to pay off student loans?
Example: Jim has to pay a $10,000 student loan debt to a private lender. Assuming that Jim’s foray into the crypto industry has yielded $20,000 worth of ether over the years, he can simply sell $10,000 worth of digital assets and, in one swoop, erase his debt. While this approach seems like the right call, it does put Jim in a bad spot. He has sold half of his holdings and, in the process, reduced his position in the crypto market. Therefore, the amount he would have made if the prices of digital assets were to maintain an upward trajectory has been halved. There is also a capital gain tax (CGT) Jim is expected to pay whenever he sells his crypto holdings. In the United States, how much CGT is owed depends on how long a person has held the asset and his or her income tax bracket.
Read more: Crypto Tax 2021: A Complete U.S Guide
A viable alternative is to deposit the $20,000 worth of ether in a DeFi loan platform as collateral and take out $10,000 worth of loan denominated in stablecoins. Then, he can exchange the stablecoins for fiat to pay the outstanding student loan. Jim has his loan denominated in stablecoin so he does not have to deal with price volatility. Because there is no fixed repayment period, Jim can take as long as he needs to repay the DeFi loan - so long his collateral remains valuable enough to prevent risk of liquidation. This approach takes away the pressure of meeting a repayment target each month.
- Note: Stablecoins are digital assets backed by fiat currencies to enable stability. Typically, these assets maintain a 1:1 peg to a selected fiat currency. For example, USDT has a 1:1 relationship with the U.S. dollar, which means that if you hold 10 USDT tokens, the value of those tokens will be about $10.
Jim’s debt has not disappeared automatically. Instead, he has transferred his debt to a decentralized ecosystem where he has more freedom to dictate how he wants to make repayments. As an added advantage, the governance tokens or rewards can be sold to pay a fraction of the debt. For instance, USDT borrowers on Aave currently earn 1.66% APR – paid in staked Aave (stkAave) tokens – as rewards when they take out a USDT loan. Notably, the current interest rate of a USDT loan is 3.88%. In light of this, a borrower can use the earnings to pay part of the debt.
Likewise, the size of Jim’s DeFi loan will technically diminish as the price of the digital asset held as collateral rises. To better understand this possibility, it is necessary to discuss the loan-to-value (LTV) metric and how it could impact the activities of DeFi borrowers.
What is LTV?
LTV is a metric indicating the size of your loan relative to your collateral. In essence, LTV is the ratio of loan to collateral. From our example above, Jim has taken out a loan that is worth 50% of his collateral. In essence, his LTV is 50%. If he had taken a $5,000 worth loan, then the LTV would have been 75%. Although some protocols may allow users to borrow over 50% of their collateral, the goal is to ensure that the loans remain over-collateralized to avoid counterparty risks.
The LTV of a borrower is bound to fluctuate all through the duration of the loan, especially if the collateral is denominated in volatile cryptocurrencies. Assuming Jim deposits 5 ETH priced at $4,000 each as collateral, the LTV will automatically reduce if the price of ETH rises to $6,000 in the next two months. Let us do the math to back this up.
- Initial price of ETH = $4,000
- Number of ETH deposited = 5 ETH
- Initial value of collateral = $20,000
- Size of loan = $10,000
- Original LTV = 50%
- Price of ETH at the end of the year = $6,000
- Value of collateral at the end of the year = $6000 * 5 = $30,000
- LTV at the end of the year = $30,000 * 100% = 33.3%
In summary, Jim’s LTV has reduced from 50% to 33.3% because ETH experienced significant price gains. Note that this example is based on the assumption that Jim has not made any payment whatsoever. However, just as the volatility of cryptocurrencies could potentially reduce the value of the debt, it could also lead to liquidation risks (more on this later).
DeFi loan rates
On platforms such as Aave, Maker and Compound you can access loans with fluctuating interest rates. The rates are determined by several factors, including the demand for the digital asset in question. Depending on the protocol being used, you can also take out loans on DeFi protocols with fixed rates but those come in higher.
Average 30-day lending rates on Compound range from 0.01% to 5.12%, and 0.01% to 5.89% on Aave. Borrowing rates are between 2.79% and 28.06% on Compound and between 0.04% to 168.98% on Aave. Information on Maker was not available.
It is also worth mentioning there are options that do not implement any loan rates whatsoever. Here, the borrower gets to repay only the sum borrowed. An example of a DeFi solution that offers interest-free loans is Liquity.
Another concept that makes DeFi loans unique is the possibility of accessing self-repaying loans. We have already established the potential of paying back a fraction of the loans with rewards earned by depositing digital assets as collateral. Some protocols take this system a little further by incorporating interest-generating opportunities for enabling a self-repayment scheme.
Here, the protocol uses the collateral as capital to fund yield farming operations on other protocols. What this means is that the protocol takes the collateral and deposits it on other DeFi platforms where it can generate interest. Subsequently, the earnings are used to repay the debt repayments over time. In other words, the loan will eventually be canceled by the potential income generated by putting your collateral to good use. Alchemix is an example of a platform that offers this type of service.
What are the risks involved with DeFi loans?
Seeing that DeFi loan is a relatively new concept, it is no surprise it comes with risks. Be sure to consider the following before opting to repay your student loan with DeFi.
Note that these DeFi platforms have liquidity thresholds – the LTV at which collaterals are sold off by the protocol to settle debts. From our original example where Jim borrowed $10,000 at 50% LTV, let’s assume that the liquidation threshold is set at 75% LTV. Hence, Jim must ensure that the value of his loan is kept below ¾ of the total value of his collateral, even if the price of ETH drops astronomically.
Jim could incur liquidation risk if the price of ETH drops from $4,000 to $2,800, thereby causing the value of the collateral to slump from $20,000 to $14,000. In this scenario, Jim must either deposit more collateral or pay the loan instantly. If he fails to complete any of these two actions before the price of ETH slips to $2,680, the protocol will liquidate the collateral to pay the $10,000 loan.
DeFi loan protocols often offer variable rates as the APR fluctuates depending on the demand and supply of digital asset loans. In such cases where the APR increases, DeFi loans become expensive. For those planning to opt for self-repaying loans or other reward-generating techniques, the lack of stable interest rates makes it difficult to accurately gauge how long it would take to repay loans.
Smart contract issues
DeFi protocols are powered by smart contracts, which automate the processes involved in borrowing loans. It is worth mentioning that the underlying codes of these smart contracts are written by humans. Hence, it is impossible to ignore the possibility of encountering errors that could jeopardize the safety of users’ digital assets. We have witnessed time and again how bugs expose smart contract-based protocols to security and systemic risks.
Like every crypto-related opportunity, it is crucial to do your own research before setting out to use DeFi strategies to pay your student loan. While DeFi loans are a great way to reduce the pressure of owing traditional lenders, this technique also exposes borrowers to risks.