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DeFi Lending and Borrowing: How It Works

Lending and borrowing is one of the oldest and most fundamental financial activities. In traditional finance, this process requires banks, credit checks, paperwork, and weeks of waiting. In decentralized finance (DeFi), smart contracts have replaced the entire process with code that executes instantly, transparently, and without permission from any authority.

DeFi lending protocols allow anyone to lend their cryptocurrency to earn interest or borrow against their crypto holdings -- 24 hours a day, 7 days a week, with no intermediaries, no credit scores, and no geographic restrictions. By 2026, these protocols collectively manage tens of billions of dollars and have processed trillions in cumulative volume.

This guide explains exactly how DeFi lending works, the mechanics behind interest rates and liquidations, the leading protocols, and how to participate safely.

How Traditional Lending Works (and Why DeFi Is Different)​

In the traditional banking system, lending involves several intermediaries and processes:

  1. A depositor places money in a savings account, earning a small interest rate.
  2. The bank uses those deposits to make loans to borrowers.
  3. The bank assesses the borrower's creditworthiness through credit checks, income verification, and collateral evaluation.
  4. The bank earns the spread between the interest rate charged to borrowers and the rate paid to depositors.
  5. If a borrower defaults, the bank absorbs the loss (or passes it to insurance/taxpayers).

This system has several limitations: it excludes people without credit history, it is slow, it is opaque (you cannot see how the bank is using your deposits), and it concentrates enormous power in financial institutions.

DeFi lending replaces the bank with a smart contract. There are no credit checks because all loans are overcollateralized -- borrowers must deposit more value in collateral than they borrow. Interest rates are determined algorithmically by supply and demand. And every transaction is visible on the public blockchain.

The Mechanics of DeFi Lending​

Supplying (Lending) Assets​

When you lend assets on a DeFi protocol, here is what happens:

  1. You deposit tokens (e.g., USDC, ETH, WBTC) into the protocol's smart contract.
  2. You receive receipt tokens (sometimes called aTokens on Aave, cTokens on Compound) representing your deposit plus accruing interest.
  3. Your deposited tokens enter a lending pool that borrowers can draw from.
  4. Interest accrues to your position every block (approximately every 12 seconds on Ethereum).
  5. You can withdraw your deposit plus earned interest at any time, subject to liquidity availability.

The interest you earn comes directly from borrowers. The protocol takes a small cut (called the reserve factor) to fund its treasury and cover potential bad debt.

Borrowing Assets​

Borrowing in DeFi works differently from traditional loans:

  1. You first deposit collateral into the protocol. This collateral must exceed the value of what you want to borrow.
  2. Based on the Loan-to-Value (LTV) ratio for your collateral type, the protocol calculates how much you can borrow. For example, if ETH has an LTV of 80%, depositing $10,000 worth of ETH allows you to borrow up to $8,000.
  3. You borrow the desired token from the lending pool. Interest begins accruing immediately.
  4. You can use the borrowed funds for any purpose -- there are no restrictions.
  5. You repay the loan plus interest whenever you choose. Your collateral is released upon repayment.

There are no fixed terms, monthly payments, or maturity dates. Your loan remains open indefinitely, as long as your collateral ratio stays above the liquidation threshold.

Interest Rate Models​

DeFi lending protocols use algorithmic interest rate models that respond to market conditions in real time.

The fundamental principle is utilization rate -- the percentage of deposited assets currently being borrowed:

Utilization Rate = Total Borrowed / Total Supplied

When utilization is low (lots of deposits, few borrowers), interest rates are low to encourage borrowing. When utilization is high (most deposits are borrowed), interest rates increase sharply to encourage repayment and attract new deposits.

Most protocols implement a kinked interest rate curve:

  • Below optimal utilization (e.g., 80%): Interest rates increase gradually.
  • Above optimal utilization: Interest rates increase steeply. This prevents the pool from being fully drained, ensuring lenders can always withdraw.

This model ensures that interest rates self-adjust to balance supply and demand without any human intervention.

Liquidation Mechanics​

Liquidation is the mechanism that keeps DeFi lending solvent. Here is how it works:

  1. Every borrower's position has a health factor -- a ratio of their collateral value to their debt value, weighted by the liquidation threshold.
  2. If the value of your collateral drops (or the value of your borrowed asset rises) to the point where your health factor falls below 1.0, your position becomes eligible for liquidation.
  3. Liquidators -- bots and traders monitoring the blockchain -- repay part of your debt and receive a portion of your collateral at a discount (the liquidation bonus, typically 5-10%).
  4. This process continues until your health factor is restored above 1.0.

Liquidation protects the protocol from insolvency but can be costly for borrowers. Careful monitoring of your health factor and using conservative LTV ratios significantly reduces liquidation risk.

Example: You deposit $10,000 in ETH and borrow $6,000 USDC. If ETH's price drops 35%, your collateral is now worth $6,500. If the liquidation threshold is 82.5%, your maximum debt before liquidation is $5,362. Since your debt ($6,000 + interest) exceeds this, liquidators step in, repay part of your debt, and claim your ETH at a discount.

Leading DeFi Lending Protocols​

Aave​

Aave is the largest DeFi lending protocol by TVL and supports markets on Ethereum, Arbitrum, Optimism, Polygon, Avalanche, Base, and other networks. Key features include:

  • Multiple collateral types: ETH, WBTC, stablecoins, and many other tokens.
  • Flash Loans: Uncollateralized loans that must be borrowed and repaid within a single transaction block.
  • Isolation Mode: Newly listed, riskier assets can be isolated to prevent contagion to the broader protocol.
  • E-Mode (Efficiency Mode): Higher LTV ratios for correlated asset pairs (e.g., borrowing USDC against USDT).
  • GHO: Aave's native decentralized stablecoin, overcollateralized and governed by AAVE token holders.

Compound​

Compound pioneered the cToken model and algorithmic interest rates. Its V3 (Comet) architecture simplifies the protocol by focusing on a single borrowable asset per market (typically USDC) while accepting multiple collateral types. This design reduces risk and improves capital efficiency.

MakerDAO (Sky)​

MakerDAO -- rebranded to Sky in 2024 -- enables users to deposit collateral and mint DAI (now also called USDS), a decentralized stablecoin. Unlike Aave and Compound where you borrow existing tokens from a pool, MakerDAO creates new stablecoins against your collateral. This mechanism is fundamental to the DeFi ecosystem's stablecoin infrastructure.

Morpho​

Morpho operates as a lending optimization layer that matches lenders and borrowers peer-to-peer when possible, falling back to pool-based lending (via Aave or Compound) when no match is available. This hybrid approach can offer better rates for both sides.

Spark (formerly Spark Protocol)​

Spark is a lending protocol that emerged from the MakerDAO ecosystem, offering competitive rates on DAI/USDS borrowing. It has grown to become a significant lending venue in its own right, particularly for users seeking exposure to MakerDAO's stablecoin ecosystem.

Use Cases for DeFi Borrowing​

Why would someone borrow in DeFi when they already have the collateral? There are several strategic reasons:

Leverage​

Borrowers can use borrowed funds to buy more of their collateral asset, creating leveraged exposure. For example, deposit ETH, borrow USDC, buy more ETH, deposit it, and borrow more -- creating a leveraged long position on ETH.

Accessing Liquidity Without Selling​

If you hold a large ETH position and need cash for expenses, you can borrow stablecoins against your ETH instead of selling it. This avoids triggering a taxable event and allows you to maintain your ETH exposure.

Yield Farming​

Borrowed assets can be deployed in other DeFi protocols for yield. If the yield earned exceeds the borrowing cost, this is profitable (though it adds risk layers).

Short Selling​

By borrowing an asset and immediately selling it, you effectively short that asset. If its price drops, you can repurchase it at a lower price, repay the loan, and keep the difference.

Arbitrage​

Traders borrow assets to exploit price discrepancies across different protocols or exchanges. Flash loans make this particularly capital-efficient since no upfront collateral is required.

Risk Factors in DeFi Lending​

Smart Contract Risk​

Despite extensive auditing, bugs can exist in lending protocol code. Major protocols like Aave and Compound have been operating for years without critical exploits, but the risk is never zero. Diversifying across protocols and using only battle-tested platforms reduces this risk.

Liquidation Risk​

If the value of your collateral drops rapidly, you may be liquidated before you can add more collateral or repay your loan. During extreme market events, network congestion can delay transactions, making it harder to manage your position.

Mitigation strategies:

  • Use conservative LTV ratios (borrow well below the maximum).
  • Set up automated alerts for your health factor.
  • Consider using stablecoin collateral if you want to avoid volatility risk.
  • Keep additional collateral ready to deposit if needed.

Interest Rate Risk​

Variable interest rates can change rapidly. If borrowing demand spikes, your borrowing rate could increase significantly, making your position uneconomical.

Oracle Risk​

Lending protocols rely on price oracles (typically Chainlink) to determine collateral values. If oracle prices are manipulated or delayed, incorrect liquidations or exploitable conditions can occur.

Liquidity Risk​

In extreme market conditions, if most of a lending pool's assets are borrowed, lenders may be temporarily unable to withdraw. The kinked interest rate model mitigates this by making borrowing extremely expensive at high utilization, but temporary withdrawal delays can still occur.

SafeSeed Tool

When interacting with DeFi lending protocols, you connect your wallet to web applications. Always verify you are on the correct website, and secure your wallet's seed phrase offline. Use the SafeSeed Paper Wallet Creator to create a durable physical backup of your recovery phrase before engaging with any DeFi protocols.

Step-by-Step: Lending on Aave​

Here is a simplified walkthrough for lending USDC on Aave (Arbitrum):

  1. Connect your wallet: Visit the official Aave interface and connect your wallet (MetaMask, Rabby, or hardware wallet).
  2. Switch to Arbitrum: Ensure your wallet is connected to the Arbitrum network for lower transaction fees.
  3. Select USDC: Find USDC in the asset list and click "Supply."
  4. Approve the token: The first time you interact with a token, you must approve the protocol to spend it. You can set a specific amount or unlimited approval.
  5. Confirm the supply: Enter the amount you want to lend and confirm the transaction in your wallet.
  6. Monitor your position: Your supplied balance and accrued interest are visible on the Aave dashboard.
  7. Withdraw anytime: Click "Withdraw" to reclaim your deposit plus earned interest.

Advanced Concepts​

Flash Loans​

Flash loans are one of DeFi's most innovative inventions. They allow you to borrow any amount of tokens with zero collateral, as long as you repay the full amount (plus a small fee) within the same transaction. If you cannot repay, the entire transaction reverts as if it never happened.

Flash loans are used for:

  • Arbitrage: Exploiting price differences across DEXs.
  • Collateral swaps: Changing the collateral backing a lending position without closing it.
  • Self-liquidation: Liquidating your own position to avoid paying the liquidation bonus to third parties.

While powerful, flash loans require technical knowledge to use directly. Several front-end tools and aggregators have made them more accessible.

Isolated Markets and Risk Tiers​

Modern lending protocols categorize assets into risk tiers. Core assets (ETH, BTC, major stablecoins) have the highest LTV ratios and deepest liquidity. Newer or more volatile assets may be placed in isolated markets where they cannot affect the broader protocol if they fail. This risk segmentation has significantly improved protocol safety.

Real-World Asset Lending​

A growing trend in 2026 is the integration of real-world assets (RWAs) into DeFi lending. Tokenized government bonds, real estate, and private credit are being used as collateral in protocols like Centrifuge and Maple Finance, bridging the gap between traditional and decentralized lending.

Learn more in our RWA Tokenization Guide.

FAQ​

What is the minimum amount needed to lend or borrow in DeFi?​

There is no protocol-imposed minimum. However, transaction fees (gas) can make very small transactions uneconomical on Ethereum mainnet. On Layer 2 networks like Arbitrum or Base, fees are typically under $0.10, making even small positions viable.

Can I lose my deposited (lent) assets?​

In normal conditions, your lent assets are safe and earn interest. However, in extreme scenarios -- such as a catastrophic smart contract exploit or a cascade of bad debt that exceeds the protocol's reserves -- lenders could theoretically face losses. This has been extremely rare in major protocols.

What happens if I get liquidated?​

If your health factor drops below 1.0, liquidators repay a portion of your debt and claim an equivalent amount of your collateral plus a liquidation bonus (typically 5-10%). You do not lose all your collateral -- only enough to restore your health factor. However, the liquidation bonus makes it costly.

Are DeFi lending rates better than bank savings rates?​

DeFi lending rates are variable and depend on market conditions. During periods of high borrowing demand, DeFi rates can significantly exceed traditional savings rates. During low demand, they may be comparable or lower. The key difference is that DeFi rates are transparent, real-time, and accessible to anyone.

Do I need to pay taxes on DeFi lending income?​

In most jurisdictions, interest earned from DeFi lending is taxable income. The specific tax treatment varies by country. Consult a tax professional familiar with cryptocurrency for guidance specific to your situation.

What is a health factor and how do I monitor it?​

Your health factor represents the safety of your borrowed position. Above 1.0 means your position is safe; at or below 1.0, you face liquidation. Most lending protocol interfaces display your health factor prominently. It is calculated as: (Collateral Value x Liquidation Threshold) / Total Debt.

How do flash loans work if there is no collateral?​

Flash loans exploit the atomic nature of blockchain transactions. The loan, usage, and repayment all happen in a single transaction. If the repayment fails for any reason, the entire transaction -- including the original loan -- is reverted by the blockchain. The lender is never at risk because the loan either gets repaid or never existed.

Can lending protocols run out of liquidity?​

Technically, yes -- if utilization reaches 100%, lenders temporarily cannot withdraw. However, the kinked interest rate model makes borrowing extremely expensive at high utilization (often 100%+ APR), which quickly incentivizes repayment and new deposits. In practice, sustained full utilization is extremely rare.