DeFi Loans Explained for Beginners

David Akilo
By David Akilo
Marcel Deer
Edited by Marcel Deer

Published March 29, 2022.

DeFi/Decentralized Finance  written in black on a white background surrounded by 1's and 0's, binary

DeFi, an acronym for "decentralized finance," is an open-source blockchain-based financial application that enables users to manage and trade assets without third-party intermediaries.

DeFi encourages transparent, permissionless, and trustless transactions across the financial services ecosystem. Investors receive high returns in the form of rewards from lending crypto assets to borrowers, participating in yield farming, or staking.

What Is DeFi Lending?

DeFi lending is a fast-growing multi-chain lending service that allows users to enlist their cryptocurrencies on a DeFi platform for lending. Borrowers access the DeFi platform and obtain direct loans via a peer-to-peer process (absent of any intermediaries), while lenders on the platform earn juicy interests on their loans.

The high-interest rates available on DeFi platforms play an incentivizing role and encourage lenders to lock up their assets on these platforms. DeFi interest rates are usually higher than lending rates in traditional finance alternatives. Some of the biggest DeFi lending protocols include Maker, Aave, and Compound. Together these protocols hold around $9 billion in market capitalization.

How Do DeFi Loans Work?

Save for value appreciation; idle crypto-assets do not earn interest. DeFi loans provide an earning mechanism for crypto assets by connecting borrowers and lenders and implementing interest rates that encourage lending. A lender provides loans to a borrower, who will then pay returns on the investment with interest on top of the initial amount invested.

Using this approach, DeFi protocols provide lending services for individuals in the same vein as traditional lending through banks. However, the difference is that DeFi loans are decentralized and absent intermediaries or restrictions. With DeFi, anybody can access the system and become a lender.

A four-step process kickstarts the business of DeFi loaning:

  1. Borrowers on the platform deposit collateral
  2. The platform pays out loans via smart contracts
  3. Borrowers pay interest for borrowing cryptos
  4. Paid interest goes to the platform's lenders

For many DeFi protocols, obtaining loans may require the borrower to provide collateral, but this isn't always the case. Some DeFi platforms seek to push the idea of decentralization further and expand their reach to borrowers by creating uncollateralized loan options.

How Do You Loan Crypto?

In every DeFi protocol, the lending process involves two participants; lenders and borrowers.

  • For Lenders Lenders need a crypto wallet. A crypto wallet allows lenders to fund accounts on the go and grant access to liquidity for borrowers.
  • For Borrowers While lenders provide the much-needed liquidity pool, borrowers are the group that approaches such pools for access to loans. To request a crypto loan, the borrower stakes a certain amount of collateral. The collateral must be equal to or more than the loan request.

If borrowers pay off the loan successfully, they will automatically receive the collateral deposited. It is important to note that DeFi lending platforms usually draw up their preferred lending tokens rate. The rates aren't consistent and depend on the protocol.

For example, DeFi interest rates for crypto coins start from 3% to 8%, whereas for stablecoins, the rate varies from 10% to 18%. These rates are open to the public and help inform lenders' strategies.

What Should Beginners Be Aware of With DeFi Loaning?

Participating in lending protocols is easy, but there are some crucial things to be aware of as a beginner.

  • Users must be careful of committing to early-stage projects and untested DeFi lending protocols to avoid scams.
  • Since lending rates vary with each protocol, checking and comparing lending rates on different DeFi protocols before committing to any of them is important.
  • Reduce the chance of falling victim to malicious attacks or rug pulls by properly researching protocols, verifying their team's credibility, and ensuring their code is audited by a third party.
  • Borrowers must be aware that the volatile crypto market can cause under-collateralization, which occurs when the collateral a borrower puts in drastically reduces in value compared to the loan request.

Are DeFi Loans Worth It?

DeFi comes with interesting perks for its users. These merits are currently unavailable in traditional finance. Its unique advantages cut across all participants, lenders, and borrowers alike. Margin trading options present higher interest rate earnings for long-term lenders. At the same time, borrowers from all over can partake in a censorship-free financial environment without fear of exclusion based on status or partiality.

Leveraging blockchain technology, DeFi loans offer an improved and truly decentralized method of conducting the age-old financial service of lending by eliminating the need for third parties. However, DeFi lending still comes with certain risks. There is the possibility of rug pull schemes, protocol code vulnerabilities, flash loan attacks, liquidations, impermanent loss, and regulatory uncertainty. Regardless, the technology behind DeFi is still nascent. Further evolution of blockchain technology could create solutions that eliminate the current issues plaguing the DeFi space.