DeFi Lending and Borrowing: How Aave, Compound & MakerDAO Work

How Does DeFi Lending Work?

DeFi lending protocols act as decentralized money markets — automated by smart contracts instead of banks. Lenders deposit crypto assets into a shared pool and earn interest continuously. Borrowers take loans from that pool by providing collateral worth more than their loan (overcollateralization). The entire process is instant, permissionless, and runs 24/7.

Unlike traditional loans, there are no credit checks, no approval processes, and no paperwork. Interest rates adjust automatically based on supply and demand — when borrowing demand is high, rates increase to attract more lenders. When demand is low, rates decrease.

The Lending Lifecycle

1. Deposit (Supply): You deposit ETH, USDC, or other supported assets into the protocol's lending pool
2. Earn interest: Your deposit immediately starts earning interest, compounded every block (~12 seconds on Ethereum)
3. Receive receipt tokens: You get tokens representing your deposit (aTokens on Aave, cTokens on Compound) that grow in value as interest accrues
4. Borrow (optional): Using your deposit as collateral, you can borrow other assets up to a certain percentage of your collateral value
5. Monitor health factor: If borrowing, track your health factor — if collateral value drops too low, you get liquidated
6. Withdraw anytime: Lenders can withdraw their deposits + accumulated interest whenever they want (subject to pool liquidity)

Top DeFi Lending Protocols Compared

Understanding Liquidation

Liquidation is the biggest risk when borrowing in DeFi. Here is how it works:

• Health Factor: A ratio measuring your collateral value vs. debt. Above 1.0 = safe. At 1.0 = liquidation begins. Aave shows this prominently in your dashboard.
• Liquidation threshold: Each asset has a threshold (e.g., ETH at 82.5% on Aave). If your loan-to-value ratio exceeds this, liquidators can repay part of your debt and claim your collateral at a discount.
• Liquidation penalty: Typically 5-10% of your collateral goes to the liquidator as a bonus for maintaining system health.

Example: You deposit $10,000 of ETH and borrow $7,000 USDC. If ETH price drops 20%, your collateral is now $8,000 and your health factor drops below 1.0. A liquidator repays $3,500 of your debt and claims ~$3,850 of your ETH (including the 10% penalty).

How to Lend on Aave (Step by Step)

1. Visit app.aave.com and connect your MetaMask wallet
2. Select a market: Choose Arbitrum or Base for lowest gas fees
3. Click "Supply" next to the asset you want to lend (e.g., USDC, ETH)
4. Enter amount and approve the transaction in your wallet
5. Monitor earnings: Interest accrues to your aToken balance automatically
6. Withdraw anytime: Click "Withdraw" to retrieve your deposit + interest

Advanced: Why People Borrow in DeFi

Why would someone pay interest to borrow crypto when they already have collateral? Common reasons:

• Leverage trading: Borrow stablecoins against ETH to buy more ETH (amplifies gains and losses)
• Tax efficiency: Borrowing against crypto avoids triggering a taxable sale event
• Liquidity access: Get cash without selling long-term holdings you believe will appreciate
• Yield farming: Borrow assets to farm higher yields elsewhere
• Shorting: Borrow a token you expect to decrease in price, sell it, buy back cheaper

Key Takeaways

• DeFi lending is automated by smart contracts — no banks, no credit checks, instant
• Lenders earn 3-8% APR on stablecoins; borrowers must overcollateralize
• Aave v3 is the largest protocol with $30B+ TVL across 10+ chains
• Liquidation occurs when your health factor drops below 1.0 — monitor positions closely
• People borrow for leverage, tax efficiency, and yield farming — not just because they need cash

Frequently Asked Questions

How does DeFi lending work?

Smart contracts match lenders and borrowers. Lenders earn interest; borrowers provide 150-200% collateral. No credit checks or paperwork.

What is collateralization?

Depositing assets worth more than your loan. If collateral drops below the liquidation threshold, your position is automatically sold.

Can you lose money lending?

Risks exist (smart contract bugs, bad debt), but lending on established protocols like Aave has a strong safety record.

What is a flash loan?

An uncollateralized loan borrowed and repaid in a single transaction. Used for arbitrage and liquidations.