How Loans Work
A surprising number of people worldwide have little understanding of how the modern monetary system works. This lack of financial literacy can have significant impacts on individuals and their ability to become more productive members of society. For instance, many people think that debt is bad without understanding that it’s an essential ingredient for growth.
All of the world’s major economies operate a debt-based model which is paramount to ensure continued growth and expansion. Without the ability to create debt, growth is dictated by the current level of productivity.
If a business produces a surplus of $2,000 a month it can only reinvest this amount to expand each month. With debt, however, this surplus can be leveraged to create a lump sum in the form of a business loan to rapidly expand and create exponential growth.
Debt only becomes a problem when it exceeds productivity or growth. In such a situation the burden of the debt weighs heavily on a business and it becomes counterproductive. This can lead to job cuts, sell-offs, and contraction instead of expansion.
Just as growth within the physical world is dependent on leveraging debt the same principles also apply to the digital world. By using debt sensibly people are able to grow their portfolios more rapidly and move towards securing their financial freedom.
A key differentiator between the loan structures of the physical and digital worlds however is that digital loans are more focused on equitable transactions. DeFi loans for instance are based on the principle of benefitting both the lender and the borrower, with the protocol taking a small percentage of the fees. Physical loans on the other hand are based on benefitting one side of the transaction, usually the bank.
We can witness this happening at the moment every time central banks adjust their base rate. Those with loans will see their interest rate increase by the same rate immediately. Savers however only receive a fraction of the increase in yield and this is often delayed by a few weeks or months.
Rather than adjusting interest rates on the dictates of central banks, DeFi loans are based on the available liquidity and level of demand. Rates are dynamically set and change instantaneously. When demand is high for a loan and liquidity is low this incentivizes people to lend their crypto in return for an increased yield.
Furthermore, DeFi loans are based solely on collateral and don’t involve any credit or identity checks. This makes them accessible to people from all over the world, irrespective of whether they are banked or unbanked.
While this approach may have some minor potential downsides the upsides greatly outweigh them. It enables many people to avoid predatory lenders and begin to build a better financial future for themselves and their families.
Crypto loans typically have a loan-to-value rate of around 70%. That means you need to deposit $1000 of crypto to borrow $700. Although it may seem strange when viewed in those terms, over-collateralization is the same when you apply for a home loan.
Banks may offer a higher loan-to-value rate of 85%, however, they own the property until the loan is paid in full. If their margin slips or the borrower fails to make repayments they foreclose on the loan and sell the property in the same way crypto loans liquidate.
The benefit of crypto loans for investors in the space is that they can quickly and easily unlock some of the liquidity of their tokens without having to sell them. In market conditions such as the present ones, it means people can grow their portfolios while prices are still low. As the cycle moves onto its next growth phase they can settle their loans with some of the profits from their new tokens.
Additionally in many parts of the world selling tokens is considered a taxable event, meaning that you may have to pay tax on the proceeds of your trade. Loans however are not considered taxable events because you haven’t disposed of any of your tokens. This enables investors to concentrate on maximizing the growth potential of their portfolios and time their taxable events more effectively.
As the space grows and people become more financially literate they will also become more nuanced in their approach to investing. As such the ability to borrow and lend crypto will be an essential part of growing both the ecosystem and the portfolios of investors. From this perspective, DeFi is as critical to the digital economy as banks are to the physical economy.