From RFR to Repayments A Practical Guide to DeFi Interest and Borrowing

The world of decentralized finance has grown from a handful of experiments into a complex ecosystem that mirrors, and sometimes surpasses, traditional banking structures. Yet the fundamentals remain the same: capital moves, interest is earned or paid, and borrowers and lenders navigate risk and return. Central to this dance is the risk‑free rate (RFR) – a benchmark that anchors all subsequent calculations of borrowing costs and repayment schedules, and can be understood in depth in our guide on Calculating the Crypto Risk Free Benchmark for Decentralized Borrowing.

Understanding how RFR flows into DeFi borrowing and how borrowers manage repayments is essential for anyone who wants to use the system efficiently and safely, a topic covered in Decoding Borrowing Mechanics in DeFi From Interest Rates to RFR. This guide walks through the steps from selecting an appropriate RFR to managing the final repayment, with practical examples that illustrate each concept in action.

Risk‑Free Rate in the Crypto Ecosystem

Risk‑free rate is the theoretical return on an investment with no default risk. In traditional finance it is often associated with government treasury bonds, but in crypto the definition is more nuanced. Because there is no single “risk‑free” asset, DeFi protocols approximate it using a combination of on‑chain data and external references.

How RFR is Determined

Most protocols rely on Chainlink price oracles to pull the price of a stablecoin that is pegged to a fiat currency, such as USDC or DAI. The chain link then compares that price to a reference rate published by a trusted institution (for example, the U.S. Treasury yield on 10‑year notes). The resulting value is treated as the baseline risk‑free rate for the protocol.

Some newer protocols use UMA (Universal Market Access) or KeeperDAO to generate on‑chain risk‑free rates that factor in the health of the liquidity pool itself. These methods allow the RFR to be recalculated every block, providing a more dynamic benchmark.

Why RFR Matters in DeFi

• Benchmarking: All borrowing rates are expressed as a spread above the RFR.
• Stability: A well‑chosen RFR reduces volatility in borrowing costs.
• Transparency: Because the RFR is publicly available, borrowers can audit the rate that feeds into their debt.

From RFR to Platform Borrow Rates

Once a protocol has a reference RFR, it must add a risk premium and a liquidity premium to arrive at the final borrowing rate. This step reflects the additional cost of risk associated with the asset’s volatility, the health of the collateral pool, and the expected yield of the protocol. The relationship is described in detail in Building Stable Interest Curves in DeFi Lending Protocols.

Risk Premium

The risk premium compensates lenders for exposure to potential defaults, smart‑contract risk, and oracle manipulation. The premium is often expressed as a fixed percentage, such as 1–3 %, and is typically transparent in the protocol’s documentation. For a deeper dive into how these spreads are quantified, see Navigating DeFi Loan Terms Through Quantitative Rate Analysis.

Liquidity Premium

If a protocol has limited liquidity for a particular asset, lenders demand a higher return to compensate for the difficulty of withdrawing funds. This premium can vary significantly between assets; for instance, a popular stablecoin might have a very low liquidity premium, while a niche altcoin could carry a substantial one.

Example Formula

Borrow Rate = RFR + Risk Premium + Liquidity Premium

In practice, many protocols compute the rate continuously using the following simple rule:

Borrow Rate = RFR * (1 + Risk Spread) * (1 + Liquidity Spread)

Both spreads are expressed as decimals, so a 2 % risk spread is 0.02.

Calculating Borrow Rates: A Practical Walk‑Through

To see how these concepts play out, let’s walk through a concrete example. Suppose you want to borrow USDC on a popular platform that sets the following parameters:

The daily borrowing rate is calculated as:

Daily Rate = 0.05% * (1 + 0.02) * (1 + 0.015)
           ≈ 0.05% * 1.02 * 1.015
           ≈ 0.0516%

If you borrow 10 000 USDC for 30 days, the total interest accrued is:

Interest = Principal * Daily Rate * Days
         = 10 000 * 0.000516 * 30
         = 155.20 USDC

This simple arithmetic demonstrates that the borrowing cost is not a static figure; it is a moving target that reflects real‑time market conditions.

Interest Accrual Models in DeFi

Protocols implement one of several accrual models. The two most common are simple interest and compound interest. A detailed comparison is provided in The Algebra of DeFi Borrowing From Simple Interest to Complex Yield.

Simple Interest

Interest is calculated once at the start of the borrowing period and applied at the end. This model is straightforward but can be less attractive to lenders because it does not reward them for longer stays.

Simple Interest = Principal × Rate × Time

Compound Interest

Interest is added to the principal at regular intervals (e.g., every block, every day). Subsequent calculations use the new, larger balance, leading to exponential growth.

Compound Interest = Principal × (1 + Rate)^Time – Principal

Most large protocols use daily compounding because it balances accuracy with computational efficiency. For borrowers, compound interest means higher eventual repayment amounts but also allows them to lock in a lower daily rate for a longer period.

Repayment Mechanics

Once you have borrowed, the repayment process is governed by several rules that ensure both lenders and borrowers are protected.

Timing of Repayments

• Daily Accrual: Most platforms accrue interest daily, meaning the debt balance increases each day.
• Auto‑Renew: If you fail to repay at the end of the period, the debt continues to accrue until it is settled or liquidated.

Liquidation Thresholds

Each asset has a minimum collateralization ratio (MCR). If your collateral value falls below this threshold, the protocol will automatically liquidate part of your collateral to cover the debt. The liquidator receives a portion of the collateral as a reward, while the remaining collateral is used to pay down your debt.

Partial Repayments

Borrowers can repay any amount, from a fraction of the debt to the entire balance. Partial repayments reduce the outstanding principal and, consequently, the daily interest accrued.

Gas Considerations

Because each repayment transaction requires on‑chain execution, gas fees can be a significant cost, especially on congested networks. Borrowers often schedule repayments during low‑traffic periods to reduce fees.

Managing Repayments: Best Practices

1. Monitor the RFR
   Keep an eye on the underlying RFR. Sudden changes can alter your borrowing cost dramatically.

2. Set Alerts
   Use on‑chain monitoring tools or services like Tenderly to receive notifications when your collateralization ratio drops near the liquidation threshold.

3. Plan for Volatility
   If the collateral is an altcoin, consider setting aside a buffer of additional collateral to protect against price swings. See Crafting Borrowing Strategies Using DeFi Yield and Risk Metrics for strategy ideas.

4. Optimize Gas
   Batch multiple repayments into a single transaction if possible, or use flashbots to avoid frontrunning and high fees.

5. Re‑borrow Strategically
   If you anticipate a lower RFR in the near future, you might refinance your debt by repaying at the current rate and borrowing again at the new, lower rate.

A Step‑by‑Step Example on a Popular Protocol

Let’s go through a complete borrowing‑and‑repayment cycle on a well‑known platform that uses the parameters described earlier.

1. Prepare Collateral
   Acquire 15 000 USDC and 3 000 ETH.

   • USDC will serve as the stablecoin collateral.
   • ETH is used to cover gas fees for the borrowing transaction.

2. Borrow 10 000 USDC
   Execute the borrow transaction.

   • The platform reads the current RFR (0.05 %) and applies the risk and liquidity spreads.
   • Your debt balance jumps to 10 000 USDC, and a daily interest accrual begins.

3. Daily Interest Accrual
   Every day, the platform adds 0.0516 % to your debt.
   After 10 days, the debt stands at:

   10 000 * (1 + 0.000516)^10 ≈ 10 051.35 USDC
   

4. Monitor Collateralization
   If your collateral value drops due to ETH price movements, the protocol will reduce your collateralization ratio.
   If it falls below 110 %, a liquidation may occur.

5. Repayment
   After 30 days, you decide to repay the entire debt.

   • You pay 10 155.20 USDC (principal + accrued interest).
   • The protocol removes the debt record, and your collateral is returned.

6. Gas Optimization
   The repayment transaction is bundled with a withdrawal of your returned USDC.
   By using a single transaction, you saved gas that would have been incurred in two separate calls.

Risk Considerations

While borrowing on DeFi platforms offers high returns for lenders and access to capital for borrowers, it is not without risk.

Oracle Risk

The RFR and asset prices rely on oracles. A manipulated oracle feed can inflate or deflate your debt balance. Choose protocols that use multiple oracle sources and perform regular audits.

Smart‑Contract Risk

Vulnerabilities in the borrowing contract can lead to loss of funds. Always verify that the protocol has undergone third‑party security audits and that the code is open source.

Liquidity Risk

If the protocol’s liquidity dries up, you might be unable to repay or withdraw your collateral. Check the protocol’s liquidity coverage ratio (LCR) before borrowing.

Regulatory Risk

Governments may impose restrictions on DeFi operations. Stay informed about regulatory developments that could affect your ability to borrow or repay.

Putting It All Together

1. Select an RFR that aligns with your risk appetite and is sourced from reputable oracles.
2. Calculate the borrowing rate by adding risk and liquidity spreads to the RFR.
3. Understand the accrual model (simple vs compound) to anticipate your debt growth.
4. Plan repayments by monitoring collateralization, setting alerts, and optimizing gas usage.
5. Mitigate risks by choosing audited protocols, diversifying collateral, and staying updated on market conditions.

By following these steps, borrowers can navigate the DeFi borrowing landscape with confidence, ensuring that they pay the fair price for capital while protecting themselves from potential pitfalls. The synergy between a well‑chosen RFR and disciplined repayment strategy is the cornerstone of successful DeFi borrowing.

Final Thoughts

The DeFi ecosystem has matured to the point where borrowing is as routine as checking a bank account balance. Yet the underlying mechanics—risk‑free rates, interest accrual, and repayment logic—require a solid understanding to use the system safely. Armed with the knowledge of how RFR feeds into borrowing costs and how repayments are structured, participants can make informed decisions that balance risk, return, and operational efficiency.

DeFi is not static; rates, protocols, and market dynamics evolve constantly. Continuous learning and vigilance remain your best tools for staying ahead in this fast‑paced financial frontier.