ONGOING
Learn how DeFi lending and borrowing works, how overcollateralization and liquidations function, and how to use protocols like Aave safely in 2026.
DeFi Lending and Borrowing: Finance Without a Bank
DeFi lending protocols allow anyone to lend cryptocurrency and earn interest, or borrow against their crypto holdings, without applying to a bank, submitting to a credit check, or providing personal information.
The largest lending protocols, including Aave, Compound, and Morpho, hold billions of dollars in deposited assets and facilitate billions more in outstanding loans. They operate entirely through smart contracts that automatically manage interest rates, collateral requirements, and liquidations according to transparent, immutable rules.
For lenders, depositing assets earns variable interest paid by borrowers. For borrowers, depositing collateral allows them to borrow other assets. The key difference from traditional lending is that DeFi loans are overcollateralized: you must deposit more value than you borrow, which eliminates the need for credit scoring but also means borrowing is primarily useful for specific financial strategies rather than general consumption.
How Interest Rates Are Set: Supply, Demand, and Utilization
DeFi lending protocols set interest rates algorithmically based on utilization rate, which is the percentage of available assets currently borrowed.
When utilization is low, borrow rates are low to attract borrowers. When utilization is high, borrow rates increase sharply to incentivize more lenders to deposit and to discourage new borrowing, protecting liquidity for existing depositors who want to withdraw.
This creates a self-regulating market. USDC borrowing rates on Aave might be three percent when the pool is fifty percent utilized, but jump to twenty percent or more when utilization reaches ninety percent.
Lend rates (what depositors earn) are always lower than borrow rates. The spread compensates the protocol and its governance token holders. Both rates fluctuate constantly as the balance of supply and demand shifts.
Collateral, Loan-to-Value Ratios, and Borrowing Power
Every asset on a lending protocol has a Loan-to-Value (LTV) ratio: the maximum percentage of that asset's value you can borrow against it.
ETH on Aave might have an LTV of 80 percent, meaning depositing $10,000 of ETH allows you to borrow up to $8,000 of other assets. Riskier or less liquid collateral assets have lower LTV ratios.
Your health factor is the metric to monitor when borrowing. It reflects the ratio of your collateral value to your borrowed value, adjusted for the liquidation thresholds of your collateral assets. A health factor above 1 means you are safe. As it approaches 1, you are close to liquidation. Many users target health factors of 1.5 to 2 to maintain a comfortable buffer.
You can borrow any available asset regardless of what you deposited as collateral. Depositing ETH to borrow stablecoins is one of the most common use cases.
Liquidations: How They Work and How to Avoid Them
Liquidation occurs when the value of your collateral falls to the point where your health factor drops below 1. At this point, a liquidation bot repays a portion of your debt by seizing and selling your collateral at a discount.
The liquidation penalty is typically five to fifteen percent depending on the asset. This means liquidation is financially painful: you lose a portion of your collateral as a penalty on top of the loss from the price decline that triggered liquidation.
Avoiding liquidation requires monitoring your health factor and either repaying debt or adding collateral when it drops toward unsafe levels. During periods of high market volatility, prices can move quickly, and health factors that seemed comfortable can deteriorate rapidly.
Setting price alerts on your collateral assets and having stablecoins ready to repay debt quickly is a practical risk management approach. Some protocols offer notifications when your health factor drops below a threshold.
Common Borrowing Strategies and Use Cases
DeFi borrowing serves several distinct financial purposes.
Leveraged exposure: borrow stablecoins against ETH, buy more ETH, then deposit the new ETH as additional collateral and repeat. This creates leveraged long exposure to ETH. It amplifies both gains and losses and carries significant liquidation risk in volatile markets.
Tax-efficient liquidity: in some jurisdictions, borrowing against appreciated crypto assets allows you to access liquidity without selling, and therefore without triggering a taxable capital gain. Always consult a tax professional regarding your specific situation.
Arbitrage and yield strategies: borrowing one asset at a low rate to deploy it elsewhere at a higher yield is the basis of many DeFi carry trades. The spread must cover borrow costs, smart contract risk, and the opportunity cost of the locked collateral.
Short exposure: borrow an asset you expect to decline in price, sell it, and repurchase it later at a lower price to repay the loan. This is a more complex use case with significant risks.
DeFi Lending: Powerful Tools That Require Discipline
DeFi lending and borrowing have created genuinely useful financial tools that operate without gatekeepers. Earning interest on stablecoins, borrowing against crypto holdings for liquidity, and accessing leverage are all real capabilities that traditional finance restricts or overcharges for.
The risks are equally real. Smart contract exploits have drained lending protocols. Cascading liquidations during market crashes have resulted in significant losses for leveraged borrowers. Interest rates can rise sharply and unexpectedly.
Approach lending and borrowing with a clear purpose, conservative health factor targets, and a genuine understanding of liquidation mechanics before deploying meaningful capital.
This information, including any opinions and analyses, is for educational purposes only and does not constitute financial advice or recommendation. You should always conduct your own research before making any investment decisions and are solely responsible for your actions and investment decisions.
The services of Freedx are not directed at, or intended for use by residents of the United States, Canada, and the United Arab Emirates, nor by any person in any jurisdiction where such use would be contrary to local laws or regulations.
© 2025 Freedx, All Rights Reserved