What Is DeFi Lending?

Decentralized finance (DeFi) covers blockchain-based financial services, including lending, trading and payments. DeFi lending is one part of that system: in pool-based protocols such as Aave, users supply crypto assets to a shared pool, and borrowers access those funds under rules enforced by smart contracts rather than a bank.

How a lending pool works

Between a blockchain and a smart contract, it is possible to operate a shared lending pool without matching each borrower to an individual lender:

• The lender deposits cryptocurrencies into a smart contract.
• These deposits form a liquidity pool. On Aave, suppliers receive interest-bearing tokens called aTokens that represent their supplied assets.
• For a collateralized loan, the borrower supplies an accepted asset as collateral and borrows from the pool within its borrowing limit, subject to available liquidity.
• These smart contract conditions range from loan principal amount and APR to the type of collateral used to issue a loan and the loan liquidation threshold.

What can put collateral at risk?

In collateralized pools such as Aave, collateral secures the debt instead of an individual credit score. If a position becomes eligible for liquidation, an external liquidator submits a transaction that repays debt in exchange for collateral plus a bonus. Liquidation reduces bad-debt risk but does not guarantee that suppliers recover their principal. Suppliers' principal remains exposed to smart contract vulnerabilities, faulty price data and collateral shortfalls.

A borrowing limit and a liquidation threshold serve different purposes. On Aave, loan-to-value (LTV) limits the amount that can initially be borrowed against collateral. The liquidation threshold determines when an existing position has too little collateral relative to its debt. For a single-collateral position, debt exceeding that threshold's percentage of collateral value makes the position eligible for liquidation. Aave expresses this as a health factor below 1. Falling collateral prices or growing debt, including accrued interest, can move a position toward liquidation. Parameters vary by asset and market.

Hypothetical example (illustrative settings): Assume a pool allows borrowing up to 75% of collateral value and has an 80% liquidation threshold. A borrower supplying $1,000 of collateral can initially borrow up to $750. If they borrow $600, the liquidation boundary is reached when collateral falls to $750. A further fall makes the position eligible for liquidation. This example ignores interest and assumes the debt’s dollar value stays unchanged.

A related distinction is a change to new borrowing capacity: see what zero LTV means for an existing Aave loan.

Interest, repayment and withdrawals

• Principal is the loan amount.
• Borrowing APR expresses the annualized interest rate without compounding. Actual interest depends on the outstanding balance, elapsed time and applicable rates.
• In pools such as Aave, variable borrowing rates respond to the share of supplied funds that is borrowed; interest accrues while debt remains outstanding.

Annual percentage yield (APY) includes compounding, while annual percentage rate (APR) does not. In Aave's pooled model, suppliers earn interest funded by borrowers' interest payments, with a portion allocated to the protocol.

Aave borrowing positions have no fixed repayment term: they stay open while collateral requirements are met and interest continues to accrue. Borrowers can repay some or all of their debt at any time; fully closing a position requires repaying principal plus accrued interest in the borrowed asset. Collateral can then be withdrawn, subject to liquidity. Suppliers can withdraw only funds that are not currently borrowed, so withdrawals may be limited or delayed until borrowers repay or new supply arrives. Collateral backing an active loan also cannot be withdrawn if that would leave the position below its required coverage.

Series Disclaimer:

This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.

Correction (2026-10-31): DeFi is broader than lending, liquidation follows insufficient collateral coverage rather than excess coverage, and lenders are not guaranteed principal recovery.