How DeFi Lending Works: Collateral, Liquidations and the Health Factor Explained
Borrowing without a bank — but never without collateral
DeFi lending flips traditional credit on its head. There is no loan officer, no credit score and no application form. Instead, a smart contract holds a pool of assets: lenders deposit tokens and earn interest, borrowers post collateral and pay interest, and the protocol sets interest rates algorithmically from how much of the pool is currently borrowed — its utilisation. The catch, and the whole design, is over-collateralisation. Because there is no court to chase a defaulting borrower, the protocol requires collateral worth more than the loan. Want to borrow $1,000 of USDC on Aave? Expect to deposit perhaps $1,500 of ETH. That excess buffer absorbs price volatility and protects lenders — and it is the reason DeFi lending works at all without identity.
Loan-to-value, liquidation thresholds and the health factor
Two numbers govern every position. The loan-to-value (LTV) ratio caps how much you can borrow against your collateral — ETH on Aave V3 sits around 80%, so $30,000 of ETH supports up to $24,000 of borrowing at maximum LTV. The liquidation threshold is the line that triggers liquidation: for ETH on Aave V3 Ethereum it is about 82.5–83%. Both feed the single most important number in DeFi lending, the health factor: collateral value multiplied by its weighted liquidation threshold, divided by total debt. Take $30,000 of ETH borrowed against $20,000 of USDC: ($30,000 × 0.825) / $20,000 = 1.2375. Above 1, the position is safe from liquidation; below 1, anyone — usually an automated liquidator bot — can repay part of your debt and take your collateral at a bonus, typically 5–10%. Aave's standard close factor lets a liquidator repay up to 50% of the debt in one liquidation. Note what moves the number even when prices stand still: interest accrues block by block, so growing debt slowly drags the health factor down on its own.
Why interest rates move on their own
DeFi rates are not set by a committee. They follow utilisation: as more of a pool gets borrowed, rates rise to attract new lenders and discourage new borrowing; as borrowing falls, rates ease. Many protocols use a kinked model, with a sharp rate increase above an optimal utilisation point, which self-corrects before a pool runs dry. For lenders, that means yield is variable and highest exactly when demand is hottest — and also when risk is highest. For borrowers, it means the cheap loan you opened can get expensive if the pool fills up, and there is no fixed monthly schedule to hide behind: you repay when you choose, but the protocol liquidates when it must, whether you are watching or not.
The risks no interest rate can price away
Liquidation is the headline risk, but it is not the only one. Oracle risk: if a price feed reports a wrong price, positions can liquidate on false data. Smart-contract risk: a bug in the protocol can drain a pool regardless of your health factor. Liquidity risk: during a crash, liquidators and network congestion can delay or worsen execution, and your collateral can gap past your liquidation price. And correlated-collateral risk: borrowing a stablecoin against ETH feels safe until ETH and the whole market fall together. Practical defences follow from the maths: borrow well below maximum LTV — experienced users often use 50–60% of their max — keep the health factor comfortably above 1.5 as a rule of thumb, prefer collateral and debt that move together if you must borrow aggressively, and never treat a health factor near 1 as "fine for now" during volatile weeks.
A beginner's checklist before your first DeFi loan
Deposit only collateral you understand, check its LTV and liquidation threshold before borrowing, and size the loan from the liquidation price, not from the maximum the interface allows. Write down the collateral price at which your health factor hits 1 — in the example above, ETH falling from $30,000 of collateral value toward about $24,240 pushes the factor to 1 — and set an alert well above it. Remember that supplying assets and borrowing against them are two different exposures: your deposit earns yield, but enabling it as collateral puts it in liquidation's reach. DeFi lending is powerful precisely because it removes the bank; it is unforgiving for exactly the same reason.
FAQ
What is over-collateralisation? The requirement to deposit collateral worth more than the loan — for example $1,500 of ETH to borrow $1,000 of USDC — because the protocol has no credit checks or courts to fall back on.
What is the health factor? (Collateral value × liquidation threshold) / debt value. Above 1 the position is safe; below 1 it can be liquidated.
What happens in a liquidation? A liquidator repays part of your debt (up to 50% on Aave) and receives your collateral plus a liquidation bonus, typically 5–10%.
Why do DeFi interest rates change? They follow pool utilisation algorithmically: more borrowing pushes rates up to attract lenders and cool demand.
What health factor should beginners target? Keep it comfortably above 1.5 as a rule of thumb, and borrow well below maximum LTV — the closer to 1, the closer to liquidation.
Read more on Zimbuck: https://zimbuck.com/pages/zimbucknews and join the discussion at https://zimbuck.com/groups/zimbuckmarketnews . Related reading on the site: the DeFi TVL guide in the DeFi category.
This article is market news and general information only, not financial advice.
