DeFi Lending and Borrowing Explained: Aave, Compound and More
Earn interest on idle crypto or borrow against your holdings without selling. This guide explains DeFi lending protocols, interest rates, liquidation, and risk management.
DeFi lending protocols let anyone earn interest by supplying assets to a shared pool, or borrow assets by posting collateral. Unlike banks, everything is transparent, permissionless, and governed by smart contracts.
How DeFi Lending Works
When you supply USDC to Aave, you receive aUSDC tokens representing your deposit. Other users borrow from the pool, paying variable interest that flows to suppliers. Rates adjust algorithmically based on utilization — if 90% of the pool is borrowed, rates spike to attract more supply.
Collateral, LTV, and Liquidation
- LTV (Loan-to-Value): e.g. 80% LTV means you can borrow $80 per $100 of collateral
- Liquidation threshold: if collateral value drops to the threshold, your position gets liquidated
- Health factor: Aave shows a health factor > 1.0 to stay safe; < 1.0 triggers liquidation
- Liquidation bonus: liquidators get 5–10% bonus to incentivize them to clear bad debt
Overcollateralization and Why It Exists
DeFi loans are overcollateralized because there is no credit history or identity. You must post $130–$200 of collateral to borrow $100. While this limits capital efficiency, it ensures the protocol remains solvent. Flash loans are the one exception — borrowed and repaid in a single transaction.
Top Lending Protocols in 2026
- Aave V3: largest by TVL, supports 15+ chains, e-mode for correlated assets
- Compound V3: simplified "comet" model, USDC-centric
- Morpho: peer-to-peer matching layer on top of Aave/Compound for better rates
- Spark: MakerDAO's lending protocol, DAI-native, competitive rates