The mania surrounding cryptocurrencies is being fuelled by a world of possibilities. Despite varying degrees of volatility, digital tokens like Bitcoin have revolutionized financial transactions.
Perhaps one of their most exciting components is that digital currencies can be used for everything from purchases to investments and even settling student loans. The following piece delves deeper into how to pay student loans with crypto.
Student Debt in the US
Americans currently have a record-breaking $1.6 trillion in student debt. According to some of the most recent data, 43 million people in the US have student loans to pay off. And while Progressives in Congress are putting pressure on the government to cancel student debt, wide-scale student loan cancellation is unlikely in the near future.
That’s why it’s important to explore all potential avenues for settling your student debt, including using crypto assets for loan payments.
What is DeFi?
DeFi stands for decentralized finance and refers to the expansion of the crypto blockchain from simple value transfer uses to more complex financial services.
This blockchain form of financing doesn’t rely on central financial intermediaries. Instead, it uses decentralized applications that operate through smart contracts. These are automated computer programs that carry out specific actions when certain conditions are met. They are a central component of every decentralized application.
In short, DeFi applications serve the same purpose as services rendered by traditional financial institutions but without any of the strict regulations.
Why use DeFi for loan payments?
One of the most obvious reasons to use DeFi to cover loan payments is the favorable interest rates. In some cases, interest rates are as low as zero.
There is also the fact that you can access loans with flexible repayment terms. Unlike traditional loans, DeFi loans do not require you to make repayments on a specific date every month. You could skip a month, even two months, and not have to worry about damaging your credit score. The best part is that, unlike traditional loans, you don’t have to possess an excellent credit score to access DeFi loans since they are issued through smart contracts.
Furthermore, with DeFi you can take out loans against your crypto holdings and avoid paying capital gain taxes on digital assets that have been sold. These and other perks are intended to reward those who are contributing to the DeFi system with their activities.
How can DeFi be used to pay off student loans?
Here is an example of how a DeFi loan is used to cover student debt.
- Debt: $20,000.
- Crypto holdings: $40,000 worth of ether
In this case, it would be easy to settle the debt by selling off $20,000 worth of ether. However, from a financial standpoint, this isn’t a wise decision because the decrease in crypto holdings reduces the holder’s position in the crypto market. If the digital assets suddenly spike in value, the holder’s potential gains are dramatically reduced. The downside is even more significant when we consider the capital gain tax the holder has to pay on the sale of the crypto assets. For example, in the US, CGT is calculated by how long assets have been held and the income tax bracket of the holder.
Hence, simply selling off the crypto won’t do. A much more suitable option would be to deposit the entire crypto holdings in a DeFi loan platform and get a secured loan worth $20,000 in stablecoins. The stablecoins can then be exchanged for fiat currencies and used to pay the debt. Moreover, stablecoins eliminate price volatility concerns.
Another advantage is that there is no fixed repayment period, so the holder can take as long as they want to repay the loan. Bear in mind, however, that this plan is only viable so long as the crypto holdings used as collateral remain valuable.
This approach won’t make the debt disappear. Instead, it transfers the debt to a system with flexible repayment terms and even rewards.
DeFi loans are also useful thanks to the possibility of self-repaying loans. It’s possible to use rewards earned from the collateral deposited in DeFi loans to offset some of the debt.
Another option is to have the DeFi protocol use the deposited collateral to fund activities on other protocols. Here, the collateral generates interest, which can be used to settle the debt over time.
What are the risks of DeFi loans?
DeFi platforms come with thresholds for liquidity. These liquidity thresholds are the loan-to-value rate at which collateral is sold to settle a debt. Borrowers must ensure that the value of their loans is kept at a certain percentage of their collateral’s total value, even if the price drops. If they don’t, they could incur liquidation risk.
Issues with Smart Contracts
While the whole DeFi process is automated and controlled by smart contracts, the codes that created this software were written by actual people. And as is human nature, errors are inevitable. Such errors could cause detriment to people’s digital assets.
As is the case with everything related to crypto and your finances, you must do your research before going all in. DeFi loans are a great way to reduce student loans using crypto, but they also expose borrowers to some risks.