DeFi Lending Explained: How Aave-Style Money Markets Work

Lending markets are DeFi's oldest working business: depositors earn interest, borrowers pay it, and a smart contract replaces the entire bank in between. Understanding how they really work — especially liquidations — is essential before either side of the trade.

The pool model

DeFi lending doesn't match individual lenders to borrowers. Everyone deposits into a shared liquidity pool per asset; borrowers draw from it. Interest accrues every block and is split among depositors proportionally. You can withdraw anytime — as long as the pool isn't fully borrowed out.

Interest rates: pure supply and demand

Rates are set algorithmically by utilization (borrowed ÷ supplied):

• Low utilization → cheap borrowing, encouraging demand.
• High utilization → rates climb steeply — sometimes past 100% APR near full utilization — pushing borrowers to repay and attracting new deposits.

This self-balancing curve is why stablecoin lending rates spike in bull markets: traders pay dearly to borrow dollars for leverage. Depositors capture exactly that demand — you can compare live lending yields on our yields page.

Why loans are overcollateralized

There are no credit scores on-chain, so every loan is secured by more collateral than debt. Deposit $10,000 of ETH and you might borrow up to ~$8,000 of stablecoins (an 80% loan-to-value cap, varying by asset quality).

Why borrow against your own money? Because it unlocks liquidity without selling:

• Spend or reinvest stablecoins while keeping ETH upside (and deferring a taxable sale in many jurisdictions).
• Loop deposits for leveraged long exposure.
• Borrow an asset to short it.

Liquidation: the part that hurts

If your collateral's value falls (or your debt asset rises) past the liquidation threshold, anyone can repay part of your debt and seize collateral at a discount — typically 5–10%, the liquidator's incentive. It's automatic, permissionless, and happens at the worst moment by design, since that's when the market moved against you.

Surviving as a borrower:

1. Borrow well below the cap. If the max LTV is 80%, living at 75% is asking to be liquidated by ordinary volatility.
2. Know your liquidation price and set an alert well above it.
3. Keep repayment ammo ready — stablecoins on hand to top up collateral or deleverage fast during a crash, when gas is expensive and networks are congested.
4. Mind correlated collateral. Borrowing a stablecoin against an LST, fine; borrowing volatile against volatile compounds both risks.

Depositor risks

Lending isn't risk-free either: smart-contract exploits, bad-debt events (a collateral asset crashing faster than liquidators can act), utilization crunches delaying withdrawals, and oracle failures mispricing collateral. Mature markets with years of history and deep TVL — check the Lending category in our rankings — have priced and survived these; new forks mostly haven't.

Bottom line

Lending markets are DeFi's most honest yield: borrowers demonstrably pay it. Depositors should stick to battle-tested protocols; borrowers should treat the liquidation engine with the respect of something that has never once shown mercy.