DeFi services are firmly entrenched in crypto and have every reason to compete with traditional finances. Since Decentralized Finance is based on the blockchain, it does not need an administration, government agencies, or third parties to function. Instead, a P2P network for dApps allows everyone to manage their finances and other assets. Smart contracts are the main component of DeFi, as their execution is automatic. Thus, no matter where you are and your societal position, DeFi makes financial transactions accessible to everyone.
Lending is also a promising industry for DeFi. Moreover, now there are lending protocols such as Maker DAO and Compound Finance that offer low-interest rates. Thus, you can receive the required amount and convert it to fiat currency. However, how does DeFi differ significantly from traditional lending, and what benefits does it offer? Today we will examine both options and determine which is best to use in 2023.
What Is Traditional Lending?
Traditional lending involves borrowing money from a bank, credit union, or online lender at a certain percentage. Loans are either secured or unsecured and are repaid over a fixed period of time specified in the contract. The repayment period varies from a few weeks to several decades, depending on the type of loan you want to get.
Now lending is fairly developed in countries like the United States and Canada. Lenders offer many different loans such as Payday Loan, Personal Loan, Mortgage, Pawnshop Loan, Title Loan, etc. While all types of Personal Loans have relatively low-interest rates of approximately 4% to 36%, with Payday Loans, borrowers must pay between $15 and $30 for every $100 borrowed.
Turning to any financial institution, you will receive money through an intermediary: the bank itself, an online lender, or a credit union. Regardless of whom you apply to, you will need to meet a certain list of requirements for your application to be approved.
How Does Traditional Lending Work?
If you want to borrow money from a bank, you must visit the nearest branch and fill out an application. When working with an online lender, the application is filled out from any device with the Internet. You must provide personal information, such as name, address, income, etc. After that, the bank or other lender will examine the history of your payments and credit history, then decide on lending.
The approval of your application largely depends on your credit history, namely, how often you took out loans and whether you paid them on time. Credit history in the US is assessed using the FICO score, which ranges from a minimum of 300 to a maximum of 850. The better your credit, the easier you get a loan and the more favorable interest rates the lender offers you.
Another important factor influencing the approval of traditional lending is the eligibility criteria. Often pinched must meet the following requirements:
- US citizenship
- Age 18 or older
- Regular source of income that can be verified
- Active bank account for deposit
- Proof of identity (driver's license, government-issued ID, or passport)
- Contact details (often phone and email)
If your application is approved, you will receive funding within a few business days and pay off the debt within a specified period. Some lenders charge additional fees; if you are overdue, you will also have to pay extra fees.
What Is DeFi Lending?
With DeFi, loans are issued through DeFi lending and borrowing platforms, which are remarkable as they do not require third parties such as banks and allow borrowers to use cryptocurrencies for lending. "Lending has a particularly huge potential for DeFi (valued at $40.28 Billion), made available from DeFi lending protocols like Aave, Maker DAO, and Compound Finance." - Medium.
Please note that DeFi loans are often secured and require a certain amount of cryptocurrency as collateral for the loan. Thanks to smart contracts, the process is as convenient as possible since the pledge is frozen and stored in escrow. After the loan debt is fully repaid, the cryptocurrency deposit is automatically returned to the owner.
It is impossible to name the exact interest rates in DeFi lending. Firstly, they are determined by the algorithm of the lending platform, and secondly, they directly depend on supply and demand in a specific period of time. However, since DeFi lending and borrowing do not have the same costs as banks (premises, staff, etc.), interest rates are usually much more favorable than traditional financing.
How Does DeFi Lending Work?
As mentioned, the bank is an intermediary that approves your application and allows you to receive funding while charging a percentage for their services. In the case of DeFi lending, an intermediary between the borrower and the lender is not required.
DeFi also implies that there are two parties, each pursuing its own goals. While some users want to get a percentage of their crypto assets, others seek funding opportunities. Thus, DeFi allows you to lend your cryptocurrency to another user at a rate or borrow a certain amount. The lending process is provided through a decentralized platform (P2P lending). If you are looking for proven and secure lending protocols, you can check out Aave, Maker, Compound, and GoldFinch. With smart contracts, the whole process is automatic and does not require the intervention of a bank or any other intermediary in the transaction.
DeFi Lending VS Traditional Lending. What Should You Choose in 2023?
To determine the most relevant type of lending, we compared both options according to several indicators:
- Availability. Although banks and credit unions provide financing to borrowers even with bad credit, it usually comes with high-interest rates and unfavorable lending terms. Moreover, the borrower still needs to provide data and meet several requirements for the application to be considered. DeFi, in turn, is more accessible, as it offers any user with internet access to receive funding even without good credit and eligibility criteria.
- Fees. DeFi has lower fees than banks and other traditional institutions. Since smart contracts eliminate the need for intermediation and are executed automatically, borrower fees are also reduced. Banks may also charge other fees, such as a late payment fee or prepayment penalty, which cannot happen if you use DeFi.
- Origination speed. Digital lending processes are processed much faster. In the case of a bank, you need to spend time on the road, filling out an application, waiting for approval, and receipt of funds in your account. "DeFi is backed by cloud-based services and analytics for fraud identification and detection, and machine learning calculations for optimum loan terms and risk factors." - BitcoinKe. These technologies help to significantly speed up the process of obtaining funding.
- Law compliance. Traditional financial institutions undoubtedly operate within the law, which is why they are safe in the eyes of people. This is also becoming the main reason for distrust of DeFi. However, thanks to blockchain technology and smart contracts, DeFi provides self-regulation that is in the interests of both parties and ensures compliance with federal and state laws.
- Safety. Any traditional lending involves intermediaries and the possibility of making mistakes. While DeFi platforms use smart contracts, the process is automatic, saving both parties from fraud, errors, and third parties.
- Volatility. Unlike any fiat currency, crypto assets can fluctuate in price significantly, which can cause problems in credit evaluation. In addition, cryptocurrency volatility can also lead to changes in collateral value, which will not happen in a bank if your loan has a fixed interest rate. However, in the case of variable interest, the amount is based on the index (SOFR) and can also be changed at the time of loan repayment.
- Transparency. The benefit of DeFi is that transactions are visible on the blockchain, which gives users more security and confidence in the correct operation of the platform. Traditional lending is centralized and needs to provide the level of transparency it should.
So, while the fiat currency of traditional funding is less volatile and more legally secure, DeFi still wins in terms of benefits. Flexibility, low fees, automated lending, transparency, and affordability make DeFi an innovative dApp that "has the highest lending growth rate and is the most prevalent contributor for locking crypto assets." - BitcoinKe.
DeFi can rightfully be considered a good alternative to traditional lending. Thanks to blockchain technology and smart contracts, Decentralized Finance has more favorable interest rates, minimal eligibility criteria, and fast funding. With DeFi, lending happens automatically and saves users from fraud. Thus, while traditional lending is still the market leader in 2023, DeFi has several significant advantages and every chance of scaling and daily use soon.
Disclaimer: Notum does not provide any investment, tax, legal, or accounting advice. This article is written for informational purposes only. Cryptocurrency is subject to market risk. Please do your own research and trade with caution.