Interest Rate Model

What Is an Interest Rate Model?

An interest rate model is the algorithmic framework that a DeFi lending protocol uses to dynamically set borrowing rates and supply rates for each asset in its markets. Rather than relying on human decision-makers to adjust rates, these models use mathematical formulas that respond automatically to real-time changes in pool conditions. The interest rate model is one of the most consequential design choices in any lending protocol, directly determining the economic experience of every borrower and lender on the platform.

The Role of Utilization Rate

The primary input for nearly every interest rate model is the utilization rate — the percentage of deposited assets that are currently borrowed. Utilization rate is calculated as:

Utilization Rate = Total Borrowed / Total Supplied

For example, if lenders have deposited $100 million into a USDC pool and borrowers have taken out $70 million in loans, the utilization rate is 70%.

The interest rate model maps this utilization rate to a corresponding borrowing rate. As utilization increases, borrowing rates rise. As utilization decreases, rates fall. This creates a self-regulating market: high rates discourage borrowing and attract new deposits, while low rates encourage borrowing and may prompt lenders to seek yield elsewhere.

The Kink Model Explained

The most widely used interest rate model in DeFi is the "kink" model (sometimes called the piecewise linear model or the jump rate model). It defines two distinct rate slopes separated by an optimal utilization threshold:

• Below the kink (normal zone) — Rates increase gradually along a gentle slope as utilization rises. This reflects normal market dynamics where supply and demand are reasonably balanced. A typical base rate might start at 0-2% and climb slowly to 3-5% as utilization approaches the optimal threshold.
• Above the kink (critical zone) — Once utilization exceeds the optimal threshold (typically set between 70-90% depending on the asset), rates spike sharply along a steep second slope. This aggressive rate increase serves as a powerful incentive to rebalance the pool — it punishes excessive borrowing and urgently attracts new deposits.

The kink design is deliberate. Lending protocols need to ensure that depositors can always withdraw their funds. If utilization reaches 100%, no liquidity remains for withdrawals. The steep rate curve above the kink prevents this scenario by making it prohibitively expensive to borrow when the pool is running low on available liquidity.

Key Parameters in Interest Rate Models

Protocol designers and governance participants tune several parameters to calibrate the interest rate model for each asset:

• Base rate — The minimum borrowing rate when utilization is at or near zero. This floor ensures that borrowing always has some cost.
• Slope 1 (normal slope) — The rate of increase in borrowing costs per unit of utilization below the kink. A gentle slope keeps rates competitive under normal conditions.
• Optimal utilization (kink point) — The utilization threshold where the model switches from the gentle slope to the steep slope. Setting this too high risks liquidity shortages; setting it too low means the protocol operates inefficiently with excess idle capital.
• Slope 2 (steep slope) — The aggressive rate of increase above the kink. This is typically 5-10x steeper than slope 1, designed to rapidly push utilization back below the optimal threshold.
• Maximum rate — Some models cap the borrowing rate to prevent extreme spikes that could cause cascading liquidations.

How Different Protocols Approach Rate Models

While the kink model is the industry standard, protocols implement variations that reflect their design philosophies:

• Aave — Uses a classic kink model with parameters set per asset through governance token voting. Aave's governance regularly adjusts rate parameters in response to market conditions and risk assessments.
• Compound — Pioneered the jump rate model, which is functionally similar to the kink model. Each market has its own rate configuration.
• Morpho — Takes a different approach by matching borrowers and lenders peer-to-peer when possible, offering improved rates for both sides. When direct matching is not possible, it falls back to rates from underlying protocols.

Supply Rate Derivation

The supply rate (what lenders earn) is derived from the borrowing rate rather than independently calculated. The formula is typically:

Supply Rate = Borrowing Rate x Utilization Rate x (1 - Reserve Factor)

This means lenders earn a share of the interest paid by borrowers, minus the protocol's cut (reserve factor), and weighted by how much of the pool is actually generating interest (utilization rate). At low utilization, even a high borrowing rate translates to a modest supply rate because most of the pool is sitting idle.

Why Interest Rate Models Matter for Users

For borrowers, the interest rate model determines the predictability and cost of their loans. Understanding the kink point for a given asset helps borrowers anticipate when rates might spike — if utilization is already near the kink, a small increase in borrowing demand could trigger dramatically higher costs.

For lenders, the model determines earnings potential. Pools operating just below the kink tend to offer the best risk-adjusted supply rates: utilization is high enough to generate meaningful interest but not so high that liquidity risk becomes a concern.

Governance and Model Adjustments

Changing interest rate model parameters is one of the most impactful governance decisions a lending protocol can make. Adjusting the kink point, slopes, or base rates affects every user in the market. Proposals to modify these parameters typically undergo rigorous community discussion and risk analysis before being put to a vote, reflecting their significance to protocol health and user experience.