How is DeFi interest paid?

Interest in DeFi is typically distributed continuously — accruing every few seconds to every block. On Aave, for example, you receive aTokens (like aUSDC) that automatically grow in balance as interest accrues. When you withdraw, the protocol pays your principal plus all earned interest.

Why would anyone borrow in DeFi at high interest rates?

Common reasons include: avoiding a taxable sale (borrow against BTC instead of selling it), accessing liquidity for short-term needs while maintaining price exposure, leveraged trading strategies, and arbitrage opportunities. Borrowers often benefit when the collateral asset appreciates faster than the borrowing cost.

What happens if my collateral gets liquidated in DeFi?

When your collateral's value drops below the liquidation threshold, liquidators (bots or users) can repay part of your debt in exchange for your collateral plus a liquidation bonus (typically 5-15%). You lose a portion of your collateral but your debt is reduced. Monitoring your health factor and maintaining a buffer above minimum LTV is critical.

DeFi Lending & Borrowing: Complete Guide | DeFi Explained

How DeFi Lending Works

DeFi lending protocols like Aave and Compound create money markets — pools of assets that users can deposit to earn interest or borrow from by providing collateral.

Here's the basic flow:

Lenders deposit crypto assets (USDC, ETH, DAI) into the protocol's liquidity pool

Borrowers deposit collateral and borrow from the pool

Borrowers pay interest on their loans

Lenders receive this interest as yield on their deposits

Smart contracts manage all of this automatically, 24/7, with no human involvement

Understanding Interest Rates

Unlike banks that set fixed rates, DeFi protocols use algorithmic interest rates based on utilization rate — how much of the available liquidity is currently borrowed.

Low utilization (20%): Low borrowing demand → low interest rates to attract more borrowers High utilization (90%): High borrowing demand → high interest rates to attract more lenders and discourage more borrowing

This means rates can fluctuate significantly. During market stress events, USDC borrowing rates on Aave have spiked from 5% to 50%+ in hours.

APY vs. APR: DeFi often shows APY (Annual Percentage Yield) which includes compound interest. Check whether rates are APY or APR when comparing.

Depositing (Lending) on Aave

Step 1: Connect your MetaMask wallet to app.aave.com Step 2: Choose an asset to supply (USDC is the most straightforward for beginners) Step 3: Click 'Supply' and enter the amount Step 4: Approve the transaction in MetaMask (pay gas fee) Step 5: Confirm the supply transaction (pay gas fee)

You'll receive aUSDC tokens in your wallet representing your deposit plus accruing interest. Your aUSDC balance increases every block.

Current lending rates vary by asset and market conditions:

• USDC/USDT: 3-8% APY (higher in bull markets)

• ETH: 1-3% APY

• WBTC: 0.5-2% APY

Borrowing in DeFi: Over-Collateralization

DeFi lending is over-collateralized — you must deposit more value than you borrow. This differs from traditional credit (where the bank trusts you to repay based on credit history).

Why over-collateralized? Because smart contracts can't assess creditworthiness or pursue defaulters. Instead, they ensure borrowers always have enough collateral to back the loan, with automatic liquidation if the ratio becomes unsafe.

Example:

• You deposit 1 ETH worth $3,000 as collateral

• Maximum LTV (Loan-to-Value) for ETH: 80%

• Maximum borrowable: $2,400

• Liquidation threshold: 85%

If ETH drops from $3,000 to $2,500:

• Your debt ($2,400) / collateral value ($2,500) = 96% — above liquidation threshold

• Your position is liquidated to repay the debt

The Health Factor: Aave displays a 'Health Factor' metric. If it drops below 1.0, your position is liquidated. Keep it above 1.5 to be safe.

Why Would You Borrow Against Your Crypto?

This is the question everyone asks. Why borrow at 5% interest when you could just sell?

Reason 1: Avoid taxable events In most countries, selling crypto triggers capital gains tax. Borrowing against it provides liquidity without a taxable event. You maintain your exposure to future price appreciation.

Reason 2: Short-term liquidity Need cash for a month? Borrow USDC against your Bitcoin, spend the USDC, and repay the loan when cash arrives — without selling your BTC.

Reason 3: Leveraged long Deposit ETH, borrow USDC, buy more ETH. If ETH rises 50% and your borrowing cost is 5%, you've amplified your gains. This is risky — ETH declining would bring you toward liquidation.

Flash Loans: DeFi's Killer Feature

A flash loan is a loan that must be borrowed and repaid within the same blockchain transaction. If the loan isn't repaid, the entire transaction reverses as if it never happened.

This lets sophisticated users:

• Arbitrage price differences between exchanges with zero upfront capital

• Refinance positions across protocols

• Execute complex multi-step strategies atomically

Flash loans are DeFi-native — impossible in traditional finance.

Top DeFi Lending Protocols

Aave: The largest multi-chain lending protocol. Available on Ethereum, Arbitrum, Polygon, and more.

Compound: The original DeFi lending protocol. Simpler interface, strong security track record.

MakerDAO: Borrow DAI (a decentralized stablecoin) against ETH and other collateral. One of DeFi's oldest and most battle-tested protocols.

Learn more about the risks before using these protocols in our DeFi Risks lesson.

DeFi Lending & Borrowing: Complete Guide

🎯 Key Takeaways