In 2009, a relative of mine lost his home – let’s call him Jim. His home was foreclosed on by a bank that had convinced him some years prior that his own home was itself a bank. “Take a home equity loan today and unlock the value of your most valuable asset,” they said. 🧐

Back in the early 2000’s, Jim thought he could use the loan to fix up his aging home. ‘Maybe with better windows, flooring, and heating equipment the improvements would add value,’ he thought. And, after all, the median value of real estate in New Hampshire (NH) had increased by ~14% each year from 2000-2003. [NHAR.org]

By 2006 home prices started to decline… and when the Great Recession took hold, real estate in NH dropped ~10% annually for two consecutive years. People like Jim were quickly underwater on their home equity loans and banks increasingly liquidated their collateral; in other words, they became homeless. I witnessed this firsthand and swore to never let this happen to a loved one ever again.

“Banks increasingly liquidated [Jim’s] collateral; in other words, [he] became homeless.“

Money lending is a risky endeavor for both the borrower and the lender. In order for any common person to own a home, or buy a car, banks need to determine whether the borrower can make regular payments of interest and principal. In Jim’s case, his income and credit history was sufficient for his mortgage and even a home equity loan. After all, more debt leads to more interest payments, which is how banks traditionally make money. If someone can afford it, banks will lend to them.

In traditional finance, “TradFi”, borrowers typically do not have the cash available to afford an entire house or car upfront. We borrow money that we don’t have through under-collateralized loans. A down payment of 20% is common, but some programs let people initiate a loan for as little as 5% of the asset’s value in the United States.

Generation after generation has accepted a form of debt peonage and rarely question its existence or consider alternatives to it. All of my relatives have under-collateralized loans. We all work wage jobs in order to pay back the bank which sourced its money from the Federal Reserve and other depositors at the bank. 🏦

Take my current mortgage for example: $420,000 loan with $80,000 down at 2.75% APR fixed for 30 years. These are considered very good terms in the United States. The value of the home was $500,000 when we bought it in 2020. While its value has increased over the last few years, median home prices have started to come down again. If the home value drops below what we owe on the mortgage, the bank could foreclose on our home.

Imagine there is a glut of homes on the market and our home value falls to $400,000; that’s $20,000 less than our mortgage. We would need to pay the difference in cash when called upon or else lose the house and our down payment.

I’ve seen this movie before… and it ended horribly. Risking the roof over your head is not worth it except in rare circumstances.

Let’s take a moment to understand what is required when taking out a mortgage today.

There are many fees which boost the profitability of mortgage origination: discount points, application fees, underwriting fees, appraisal fees and tax status fees. The bank charges a credit report fee to investigate the borrower’s “credit-worthiness.” Private mortgage insurance (PMI) or “points” are paid for by people with less money down as protection for the bank in case the borrower stops making payments. Title insurance pays for an investigation to ensure that nobody else technically still owns the property or has a lien on it by another entity (bank or government). Real estate agents take 2-5% as a fee on top of it all.

All of these closing costs are part of a system where inefficient middle-men and old systems slowly suck away the cash that borrowers need to pay down their principal. In Tradfi, the cards are stacked in the bank’s favor, while borrowers toil for 30 years making these middle men a fortune in fees and interest. In my example, interest costs alone will total $237,182 by 2050.

Decentralized Finance (“Defi”), blockchain technology, and digital assets are a potential solution to this – promising to break the cycle of debt peonage we all know too well.

In Defi protocols common today, the value of your collateral should be at least 120% of what you are planning to borrow. In other words, the Loan-to-Value (LTV) ratio is about 80%. The collateral could be stablecoins, such as as USDC or DAI; digital assets such as wrapped Bitcoin or ETH; or increasingly digital collectibles such as CryptoPunks or BoredApes. More blockchain-friendly assets are being created all the time and on-chain marketplaces are where their value is determined.

Let’s take a recent vehicle purchase I made as an example. All in, the vehicle cost $45,000 and my wife and I paid cash ($USD) for it. We started with $30,000 that was saved as a hefty down payment, but instead of taking a Tradfi loan to cover the other $15,000 at 6% APR, I decided to finance the balance with a Defi loan.

Benefits include:

• A lower net interest rate (under 1% APY at the time of writing),

• We hold the vehicle title instead of the bank,

• I can pay off my loan at anytime while interest grows.

Here’s how I set this up in Aave back in November 2022:

• I deposited 16 ETH ($1200/ETH at that time) as collateral by supplying it to the Defi app. Once supplied, my collateral began to earn interest at the current variable APY; +0.79% at the time. In theory, I could just leave these assets in Aave and earn interest from others borrowing from the ETH pool.

• After depositing the collateral, I went over to the borrow side and took out a loan for $15,000 USDC at a variable rate of -0.54%. This means I was being paid a variable rate of +0.25% APY while borrowing 15,000 dollars! This is not to be expected in all cases.

• Using a reliable centralized exchange – Nexo, in my case – I converted the USDC to USD and off-ramped the funds into a traditional bank account. From there I was able to pool all $45,000 cash and wire it to the vehicle manufacturer.

• The only fees I paid throughout the Defi process was on-chain transaction fees which totaled a few dollars worth of ETH on the Optimism L2.

Now, you might be wondering how the $15K is paid back and what my monthly payments are.

In Defi, there are no required monthly payments. In theory, I could sit on this loan for a year and just let it collect interest. (As of January 24, 2023 I owe $15,021 while my collateral value has increased.) An over-collateralized loan is exactly that – the value of the collateral must remain at or above 120% of the amount that was borrowed. I risk liquidation as parity approaches.

There is risk in using a volatile asset like Bitcoin or ETH, which means you should be cautious by providing extra collateral (>120%) or start paying off the loan so that LTV is below 80%. This is why it is very important to keep an eye on the health factor of the loan. If the value of my collateral falls and LTV goes above 82.50%, then the protocol will begin automatically selling off the collateral to keep the loan healthy. This is executed by code – not humans.

Aave’s health factor reflects the safety of your deposited collateral against the borrowed assets. Since the 16 ETH I deposited has increased in value since November 2022, my health factor has increased from a risky 1.17 to a much safer 2.74.

As a percentage, LTV decreases as the value of the collateral increases relative to the borrowed assets. At $1600 per ETH in January 2023, the new LTV is much lower than before.

The protocol will begin liquidating some of my collateral as soon as the borrowed value reaches 82.50%. In the above screenshot, you’ll find that I’m safely below the liquidation threshold. This is a coincidence – don’t try to time the market.

Borrowing in Defi can be a little intimidating at first, but new applications are making these processes easier to manage over time. In the future, Defi apps will directly show you the estimated value of collateral needed to prevent liquidations. They may even send urgent notifications to remind you to take action as 80% LTV approaches.

Over-collateralized loans are not a solution for everyone, but Bankless enthusiasts may find over time that their digital assets will allow them the financial freedom to become their own bank.

*Benjiming is an advisor to Bankless Academy and can be reached on Twitter @BenjimingDefi and GM.xyz @Benjiming.