DeFi lending protocols allow you to earn interest on deposits and borrow against collateral without traditional banks. It's one of the most established DeFi use cases.
How DeFi Lending Works
Basic Concept
Mechanism:
- Lenders deposit crypto
- Borrowers provide collateral
- Smart contracts manage everything
- Interest rates adjust algorithmically
Key Participants
Roles:
- Lenders: Supply assets, earn interest
- Borrowers: Deposit collateral, borrow assets
- Protocol: Matches supply and demand
- Liquidators: Close underwater positions
Lending (Supplying)
How to Lend
Process:
- Connect wallet to protocol
- Choose asset to supply
- Approve token access
- Deposit funds
- Start earning interest
Interest Rates
How Rates Work:
- Based on utilization
- More borrowing = higher rates
- Variable (changes constantly)
- Some protocols offer stable rates
What You Earn
Returns:
- Interest from borrowers
- Sometimes protocol tokens
- Compounded automatically
- Withdrawable anytime (usually)
Borrowing
How to Borrow
Process:
- Supply collateral first
- Enable asset as collateral
- Choose asset to borrow
- Borrow up to limit
- Pay interest on loan
Collateralization
Requirements:
- Over-collateralized loans (>100%)
- Typical ratios: 125-150%+
- No credit check needed
- Collateral backs the loan
Example
Scenario:
- Deposit $10,000 ETH as collateral
- Maximum LTV: 80%
- Can borrow up to $8,000
- Should borrow less for safety
Key Metrics
Loan-to-Value (LTV)
Definition:
- Borrowed amount / Collateral value
- Higher LTV = higher risk
- Each asset has max LTV
Health Factor
Definition:
- Measure of position safety
- Below 1.0 = liquidation risk
- Higher = safer
- Monitor closely
Liquidation Threshold
Definition:
- LTV level triggering liquidation
- Varies by asset
- Usually 75-85%
- Stay well below
Interest Rate Models
Variable Rates
Characteristics:
- Change with utilization
- More volatile
- Can be very high or low
- Most common type
Stable Rates
Characteristics:
- More predictable
- Usually higher than variable
- Can be rebalanced
- Not all protocols offer
Utilization Curve
Concept:
- Low utilization = low rates
- High utilization = high rates
- Encourages balance
- Prevents liquidity crunch
Major Lending Protocols
Aave
Features:
- Largest DeFi lending protocol
- Flash loans
- Multiple chains
- Stable and variable rates
- GHO stablecoin
Compound
Features:
- Pioneer in DeFi lending
- COMP governance token
- Compound III (single collateral)
- Simple interface
MakerDAO
Features:
- Creates DAI stablecoin
- Borrow DAI against collateral
- Stability fees
- Decentralized governance
Comparison
| Protocol | Specialty | Chains |
|---|---|---|
| Aave | Multi-asset lending | Many |
| Compound | Simple lending | Ethereum, L2s |
| MakerDAO | DAI stablecoin | Ethereum |
Use Cases
Earning Yield
Strategy:
- Deposit stable assets
- Earn consistent yield
- Lower risk than other DeFi
- Passive income
Leveraged Exposure
Strategy:
- Deposit ETH
- Borrow stablecoins
- Buy more ETH
- Amplified gains (and losses)
Avoiding Taxes
Strategy:
- Borrow against holdings
- Access liquidity without selling
- No taxable event
- Risk of liquidation
Note: Consult tax professional
Short Selling
Strategy:
- Borrow asset you're bearish on
- Sell borrowed asset
- Repay when price drops
- Profit from decline
Liquidations
What is Liquidation?
Process:
- Collateral value drops
- Health factor below threshold
- Third party repays loan
- Takes collateral at discount
Liquidation Penalty
Cost:
- Typically 5-15%
- Incentivizes liquidators
- Loss for borrower
- Avoidable with monitoring
Avoiding Liquidation
Strategies:
- Maintain low LTV
- Monitor health factor
- Set up alerts
- Add collateral if needed
- Repay some loan
Risks
Smart Contract Risk
Concern:
- Bugs can cause losses
- Even audited protocols hacked
- New protocols riskier
Oracle Risk
Concern:
- Price feeds can fail
- Manipulation possible
- Flash crash liquidations
Liquidation Risk
Concern:
- Volatile markets
- Can happen quickly
- May lose significant value
Interest Rate Risk
Concern:
- Variable rates can spike
- Unexpected costs
- Forced to close position
Best Practices
For Lenders
Guidelines:
- Understand the protocol
- Check audit status
- Diversify across protocols
- Start with stablecoins
- Monitor positions
For Borrowers
Guidelines:
- Use low LTV (50% or less)
- Monitor health factor
- Have repayment plan
- Understand liquidation risk
- Use stable collateral
Getting Started
Step by Step
- Research protocol - Choose established option
- Start small - Learn with minimal funds
- Supply first - Understand mechanics
- Borrow cautiously - If at all
- Monitor regularly - Check positions
Key Takeaways
- DeFi lending matches lenders and borrowers via smart contracts
- Earn interest by supplying assets
- Borrow against over-collateralized positions
- Interest rates adjust based on utilization
- Liquidation happens if collateral drops too much
- Monitor health factor closely
- Start with lending before borrowing
- Understand risks before participating
What's Next?
Learn about decentralized exchanges (DEXs) and how to swap tokens.
This article is for educational purposes only and does not constitute financial advice.
Risk warning. This is education only, not financial, investment, tax or legal advice, and not a recommendation to buy or sell anything. Trading forex, CFDs, stocks, commodities, futures, options and crypto is high-risk; with leverage you can lose more than you deposit, and most retail traders lose money. Before you trade or invest in any form, check the local laws where you are and the rules of your country of residence, and consider your own financial situation; if in doubt, ask a licensed adviser. Past and tested results, and all examples, are for illustration only and do not guarantee future results.