What is an Interest Rate Model?
An interest rate model is the mathematical function a lending protocol uses to dynamically set interest rates based on market conditions — most importantly, utilization: the percentage of deposited liquidity that is currently borrowed. When utilization is low, rates are low to encourage borrowing; when utilization is high, rates spike to attract new deposits and encourage repayment. The model is what keeps a lending market balanced, liquid, and solvent without any human setting prices by hand.
Aave, Compound, and similar protocols rely on the utilization-based “kinked” curve pioneered by Compound. The elegant idea: let supply and demand set rates automatically. When borrowers want more than depositors have supplied, the rate rises until either more depositors arrive or some borrowers repay, restoring balance. Understanding the interest rate model is essential for predicting your borrow costs and your supply yields in DeFi.
How the Interest Rate Model Works / Technical Details
Utilization Rate
The central input is utilization:
Utilization = Total Borrowed / Total Supplied
If a market has $100M supplied and $80M borrowed, utilization is 80%.
The Kinked Curve
The most common design uses a two-segment (kinked) curve with a “kink” at a target utilization (often around 80–90%):
- Below the kink, rates rise gently with utilization. Borrowing is cheap, suppliers earn a modest yield.
- At and above the kink, rates rise sharply. This is the warning zone: if utilization gets too high, there may not be enough liquidity for depositors to withdraw, so the model punishes borrowers with very high rates to force repayment and incentivize new deposits.
A simplified example with a kink at 80%:
- 30% utilization → ~3% borrow rate
- 60% utilization → ~6% borrow rate
- 80% utilization (kink) → ~10% borrow rate
- 95% utilization → ~50%+ borrow rate (steep penalty zone)
The supply (deposit) rate is derived from the borrow rate minus the protocol’s reserve factor:
Supply Rate = Borrow Rate × Utilization × (1 − Reserve Factor)
Why the Kink Exists
Without a kink, a smoothly rising curve would let utilization drift dangerously close to 100%, at which point depositors could not withdraw their funds (they’d all be lent out). The kink creates a sharp incentive cliff: as soon as utilization crosses the threshold, rates explode, rapidly pulling utilization back down. This protects liquidity for depositors.
Parameter Tuning
Each asset market has its own parameters:
- Base rate (the rate at 0% utilization)
- Slope below the kink (gentle)
- Slope above the kink (steep)
- Kink point (target utilization)
- Reserve factor (protocol’s cut)
Governance tunes these per asset. A volatile long-tail token might have a lower kink (e.g., 70%) and steeper slopes to keep more liquidity buffer; a stablecoin might run hotter (kink at 90%) because its price is stable.
Notable Examples and Patterns
Compound’s Utilization Curve
Compound introduced the canonical kinked utilization model. Its v2 markets each have an InterestRateModel contract with parameters set per asset. The design has been so influential that most subsequent lending protocols adopted close variants.
Aave’s Model and “Uoptimal”
Aave uses the same kinked structure but exposes an “optimal utilization” (Uoptimal) parameter (commonly 80% or 90%). Aave v3 also added features like “efficient mode” (e-modes) that let correlated assets (e.g., USD stables) be borrowed against each other at high LTV, which changes how utilization and rates behave within an e-mode.
Stable Interest Rates
Some protocols offer borrowers a choice between variable (floats with the model) and stable (fixed for the loan’s life) rates. The stable rate is set based on the average expected variable rate and gives borrowers predictability, though it can be rebalanced under certain conditions.
The March 2020 Stress Test
During the COVID crash of March 2020, utilization spiked across lending protocols as collateral values collapsed and liquidations lagged. The steep portion of the curve engaged, sending some borrow rates into the thousands of percent annualized. This demonstrated both the model’s strength (it correctly incentivized rapid de-leveraging) and the importance of having enough buffer below the kink in normal times.
How to Use and Reason About Interest Rate Models
For Borrowers
- Watch utilization, not just the current rate. If utilization is near the kink, your variable rate can multiply in minutes.
- Use stable rates for predictability if you plan to hold a loan through volatility.
- Avoid borrowing in highly correlated pairs where a price move can simultaneously raise your collateral factor pressure and the borrow rate.
For Suppliers
- Understand your yield isn’t fixed. Supply rates move with utilization; a popular market pays more, an idle one pays almost nothing.
- High utilization is a liquidity risk. If a market sits above the kink persistently, you may struggle to withdraw. Prefer markets that stay below their kink with comfortable headroom.
- Account for the reserve factor. The displayed supply rate already reflects it, but it explains why supply rates are always below borrow rates.
For Protocol Designers
- Set the kink and slopes to maintain a safe liquidity buffer under stress.
- Back-test against historical crashes; tune so that utilization rarely exceeds the kink for long.
- Make parameters adjustable by governance with timelocks, since market conditions evolve.
Frequently Asked Questions
Q: Why are DeFi borrow rates so much more volatile than TradFi rates? A: DeFi rates react in real time to on-chain supply and demand with no central bank smoothing them. A surge in borrowing instantly pushes utilization up and rates up with it. TradFi rates move far more slowly and are set by committees.
Q: Can I get a truly fixed rate in DeFi? A: Partially. “Stable rate” options fix your rate for the life of a specific loan, and separate fixed-rate lending protocols and rate markets exist, but truly long-term fixed rates are still less developed than in TradFi.
Q: What happens if utilization hits 100%? A: Depositors cannot withdraw until some borrower repays or new deposits arrive. The steep part of the curve is designed to make this brief, but it is a real liquidity risk — which is why healthy markets stay well below the kink.