DeFi Lending Explained: Collateral, Interest and Liquidation Risk

Key Notes

• A borrowing limit is a protocol ceiling rather than a recommended loan size.
• Falling collateral prices and rising debt can reduce the health factor of a position.
• Repaying debt, withdrawing collateral and revoking token permissions are separate actions.

A lending dashboard says you can borrow $8,400 against your crypto. That does not mean an $8,400 loan leaves room for the market to move. The interface is showing a protocol limit, while your ability to keep the collateral depends on prices, interest and liquidation rules that continue changing after you close the browser.

DeFi lending lets users supply assets to smart contracts and borrow against eligible collateral. This guide follows a loan from deposit to repayment, with a worked example showing how a position can become vulnerable even when the borrower has made no new trades.

All prices, rates and risk parameters in the examples are fictional. Aave is used to explain one common design; individual protocols, versions and markets have different rules.

What happens to supplied assets

In a pooled lending market, users deposit supported tokens into contracts that make liquidity available to borrowers. Suppliers receive a protocol-defined claim on their supplied assets, often represented by an interest-bearing token or balance. The interest depends on the market’s rules and use of that liquidity.

Aave documentation explains that supplying transfers tokens to the protocol’s contracts. Seeing a deposit in your wallet interface does not mean the underlying assets remain idle at your original address.

Supplying is also different from staking, which concerns participation in a network’s security mechanism. A lending yield comes from a different activity and carries different risks. Neither a familiar token name nor the word deposit makes the arrangement an insured bank account.

Start by identifying the protocol, network, market and exact token contract. Two assets with the same ticker can have different issuers, bridge dependencies or collateral eligibility. Our DeFi guide provides the broader context for using these applications.

Borrowing creates a token-denominated debt

A common DeFi loan requires collateral worth more than the borrowed assets. That collateral can remain exposed to market movements while the borrowed tokens become available in the borrower’s wallet. Interest adds to the obligation according to the market’s accounting.

If you borrow 6,000 units of a dollar-linked token, you generally owe that token plus interest, rather than a fixed promise to repay $6,000 in any asset you choose. Its dollar price and the cost of acquiring it can change. Even a stablecoin loan is not automatically free of currency risk.

Borrowing rules determine which collateral supports which debts and how much liquidity is available. A displayed borrowing capacity is a ceiling under current conditions, not a recommendation to use the entire amount.

Before opening a loan, describe its purpose in one sentence. Borrowing for a planned payment creates a different situation from borrowing to buy more of the same volatile collateral. The second strategy makes the outcome increasingly dependent on one market continuing to rise.

LTV and liquidation thresholds serve different purposes

Loan-to-value, or LTV, compares the value of debt with the value of collateral. A maximum borrowing LTV limits the debt a user can initially open. A liquidation threshold determines when the collateral no longer provides enough protection under the protocol’s rules.

These percentages need not be equal. A gap between them can give a newly opened loan some room before liquidation becomes possible. Different collateral assets can have different thresholds, and a position containing several assets may use a weighted calculation.

In Aave’s framework, the health factor compares collateral value adjusted for liquidation thresholds with total debt value. A factor below 1 makes the position eligible for liquidation. The protocol’s liquidation guide explains this relationship.

A health factor is a live measure, not a fixed safety certificate. The same number can behave differently for two highly correlated assets than for volatile collateral backing a stablecoin debt. There is no single setting that makes every lending position safe.

Follow a loan through a price drop

Consider a simplified market with $12,000 of one collateral asset, a maximum borrowing LTV of 70% and a liquidation threshold of 80%. The borrower takes a $6,000 loan. Assume the debt token stays at $1 and ignore interest initially.

The maximum initial borrowing capacity is $12,000 × 70% = $8,400. The actual loan uses 50% LTV. Its health factor is ($12,000 × 80%) ÷ $6,000 = 1.60.

Now the collateral price falls 25%, reducing its value to $9,000. The debt is still $6,000, so LTV rises to approximately 66.7% and the health factor falls to 1.20. No additional borrowing was needed for the risk to increase.

With unchanged debt and an 80% threshold, the health factor reaches 1 when collateral value reaches $7,500. That is a 37.5% decline from the original $12,000. Below that boundary, the simplified position becomes eligible for liquidation.

Interest moves the boundary too. If the debt grows to $6,200, collateral worth $9,000 produces a health factor of about 1.16, and the boundary rises to $7,750. A borrower cannot calculate the danger level once and assume it stays fixed.

Understand changing interest rates

Variable borrowing rates can change as demand for liquidity changes. A rate displayed when a loan opens is not necessarily the rate charged throughout its life. Supply yields can change as well, and the return on one asset does not automatically offset the cost of borrowing another.

APR and APY are different presentations. APR is an annualized rate before the effect of compounding; APY incorporates a compounding assumption. Neither tells you that the underlying rate will remain unchanged for a year.

For a simple illustration, $6,000 borrowed at an unchanged 8% annual rate would cost roughly $40 over one-twelfth of a year before compounding and other costs. If the annual rate became 24% for that same interval, the comparable amount would be roughly $120. These are arithmetic examples, not market quotes or a protocol’s exact interest calculation.

Separate interest from rewards paid in another token. An advertised net yield can look favorable because of temporary incentives whose market value may fall. Compare the underlying debt growth, collateral yield and incentive assumptions individually.

What liquidation means for the borrower

Liquidation allows an eligible party to repay some or all of a vulnerable debt and receive collateral under the protocol’s rules, typically with an incentive. The borrower can lose collateral even if they intend to hold it for years or believe its price will recover.

The amount that can be liquidated, the incentive and any additional fees depend on the market. Do not assume a universal rule that only half a position can be taken. Nor should you depend on receiving a warning early enough to act.

The relevant valuation may come from the protocol’s configured oracle, rather than the price in a portfolio app. Aave’s risk documentation covers oracle, collateral and network dependencies. A sharp change in collateral or debt-token prices can alter the position’s status quickly. A stablecoin losing its peg can matter on either side of the loan: cheaper collateral reduces protection, while a more expensive debt token can increase the debt’s measured value.

Adding collateral or repaying debt may improve a position, but both require successful transactions. Congestion, insufficient gas, a paused function or lack of the repayment token can obstruct a last-minute response. A plan that works only if you react instantly is fragile.

Withdrawals and permissions are separate from repayment

A supplied balance is not a promise of immediate withdrawal under every condition. Withdrawal documentation describes the need for available pool liquidity. If supplied assets also secure a loan, removing them must preserve the required collateral protection.

Borrowers therefore face two separate questions: how much of the asset is available in the market, and how much collateral their own position can release. A large account balance alone answers neither.

Token permissions add another distinction. Approving a contract lets it spend eligible tokens within an allowance; approval does not itself deposit collateral or repay debt. Revoking an allowance does not close a loan or withdraw supplied assets. Our approvals guide explains the permission layer.

Keep a record of the network and market where the position exists. An interface connected to another chain may show no debt even though the original loan is still active.

Suppliers also bear risks beyond a borrower’s visible health factor. Contract vulnerabilities and collateral that cannot be liquidated quickly enough can create losses. An interest-bearing receipt is a claim within that system, not protection against every shortfall. Before supplying, examine the market’s security documentation and understand which mechanisms, if any, address bad debt.

Plan and verify the exit

Before borrowing, write down the repayment asset, where you would obtain it, the collateral threshold and how you would respond to a large adverse price move. Stress-test both a collateral decline and a rise in borrowing costs. Include transaction fees and the possibility that you cannot act immediately.

Using borrowed funds to buy more collateral and borrowing again creates a loop. Each layer can amplify exposure, transaction costs and the consequences of falling prices. Several deposits in the same underlying asset do not provide independent protection.

When closing a loan, use the documented repayment flow and refresh the amount owed. Repayment guidance distinguishes partial repayment from full closure. Interest can leave a small outstanding balance if you rely on an old figure.

After confirmation, verify that debt is zero in the correct market before withdrawing the remaining collateral. Check the received assets and save the transaction records. Closing the browser, disconnecting the wallet or removing a token from its display does not end an onchain obligation.

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