How Loans Work
Comparing traditional bank loans with cryptocurrency/DeFi lending
What is a Loan?
Simple Definition
A loan is when you borrow money from someone (a lender) and agree to pay it back with interest over time. The lender charges interest as the cost of lending you money.
Key Components
- Principal: The amount you borrow
- Interest: The cost of borrowing (percentage of principal)
- Collateral: Assets you pledge as security (optional in some cases)
- Term: How long you have to repay
- Monthly Payment: Regular payments covering principal + interest
Why People Borrow
People take loans to buy things they can't afford upfront: houses, cars, education, starting businesses, or covering expenses. Loans let you use money now and pay it back over time.
How Traditional Bank Loans Work
Step 1
Apply for loan (fill forms, provide documents)
Step 2
Credit check and underwriting (days to weeks)
Step 3
Loan approval or denial
Step 4
Sign loan agreement
Step 5
Funds deposited to bank account
Step 6
Make monthly payments
How Cryptocurrency/DeFi Loans Work
Step 1
Connect wallet to DeFi protocol
Step 2
Deposit collateral (cryptocurrency)
Step 3
Smart contract calculates borrowing capacity
Step 4
Borrow against collateral (instant)
Step 5
Funds available in wallet immediately
Step 6
Pay interest or repay principal anytime
Feature Comparison
Collateral: How It Works
Traditional Loans
Types of Collateral:
- Secured Loans: House (mortgage), car (auto loan), assets
- Unsecured Loans: Credit score, income, no physical collateral
How It Works:
You pledge assets as security. If you default, the lender can seize the asset. Unsecured loans rely on your creditworthiness and legal action.
Loan-to-Value (LTV):
Typically 80-95% for mortgages, 70-90% for auto loans. You can borrow a percentage of the asset's value.
Crypto/DeFi Loans
Types of Collateral:
- Cryptocurrency: Bitcoin, Ethereum, stablecoins, etc.
- NFTs: Some protocols accept NFTs as collateral
How It Works:
You deposit cryptocurrency into a smart contract. The contract locks your collateral and allows you to borrow against it. If collateral value drops too low, automatic liquidation occurs.
Loan-to-Value (LTV):
Typically 50-75% (over-collateralized). You must deposit more value than you borrow to protect against price volatility. This is why it's called "over-collateralized."
Interest Rates Explained
Traditional Loans
Rates depend on credit score, loan amount, term length, and lender. Lower credit = higher rates.
Crypto/DeFi Loans
Rates are determined algorithmically by supply and demand in liquidity pools. More borrowers = higher rates. More lenders = lower rates.
Pros and Cons
✅ Traditional Loans Pros
- Familiar and well-established system
- FDIC/SIPC protections
- Can use for physical assets (house, car)
- Fixed interest rates available
- Consumer protection laws
- Can improve credit score
- Lower LTV ratios (borrow more relative to collateral)
❌ Traditional Loans Cons
- Slow approval process (days to weeks)
- Credit check required
- Geographic restrictions
- Paperwork and documentation
- Higher rates for poor credit
- Limited access for unbanked
- Banking hours and business days
✅ Crypto/DeFi Loans Pros
- Instant approval and funding
- No credit check required
- Global access 24/7
- Transparent and automated
- No paperwork or documentation
- Accessible to anyone with crypto
- Flexible repayment terms
- Can earn yield on collateral
❌ Crypto/DeFi Loans Cons
- Requires cryptocurrency as collateral
- Over-collateralized (must deposit more than you borrow)
- Price volatility risk (liquidation if prices drop)
- No consumer protections
- Smart contract risk
- Variable interest rates
- Technical knowledge required
- No credit building
Liquidation: What Happens When You Can't Pay
Traditional Loan Default
Missed Payments
You fail to make payments for 30-90 days
Collection Process
Lender contacts you, sends notices, may offer payment plans
Legal Action
Foreclosure (house), repossession (car), or lawsuit
Asset Seizure
Lender takes the collateral, sells it, keeps proceeds
Credit Damage
Default stays on credit report for 7 years, affects future borrowing
Crypto Loan Liquidation
Collateral Value Drops
Price of your collateral cryptocurrency falls
LTV Ratio Increases
Your loan-to-value ratio approaches the liquidation threshold (e.g., 80%)
Liquidation Warning
Protocol may send alerts, but liquidation can happen quickly
Automatic Liquidation
Smart contract automatically liquidates collateral to repay loan
Liquidation Penalty
You lose collateral (often with a penalty fee, e.g., 5-10%)
When to Use Each Type
🏦 Use Traditional Loans For:
- Buying a house (mortgage)
- Buying a car (auto loan)
- Building credit history
- Large purchases with physical assets
- When you need consumer protections
- Fixed-rate preference
🪙 Use Crypto/DeFi Loans For:
- Accessing liquidity without selling crypto
- Leveraging crypto holdings
- No credit check needed
- Fast access to funds
- Global access
- Earning yield on collateral
- Tax optimization (avoiding capital gains)
Key Takeaways
💰 Both Are Loans
Both traditional and crypto loans let you borrow money and pay it back with interest. The core concept is the same.
⚡ Speed Difference
Traditional loans take days/weeks for approval. Crypto loans are instant - connect wallet, deposit collateral, borrow immediately.
🔐 Collateral Types
Traditional uses physical assets or credit. Crypto uses cryptocurrency, requiring over-collateralization for safety.
🌍 Access
Traditional loans are limited by geography and credit. Crypto loans are global and accessible to anyone with crypto.
⚖️ Trade-offs
Traditional offers protections and lower LTV but is slow. Crypto is fast and global but requires over-collateralization and has volatility risk.
🛡️ Risk Management
Both have default/liquidation risks. Traditional has legal processes. Crypto has automatic liquidation based on collateral value.