DeFi Lending & Borrowing – How to Earn Interest and Leverage Your Assets

Introduction

Decentralized finance (DeFi) has revolutionized how people interact with money. One of its most powerful – and misunderstood – innovations is the ability to lend and borrow crypto assets without relying on banks or credit scores.

In traditional finance, borrowing requires permission. Lending is reserved for institutions. DeFi flips that model on its head. With just a wallet and a few clicks, anyone can become a lender earning passive income or a borrower unlocking capital from idle assets.

This guide will walk you through the entire DeFi lending and borrowing landscape – from the mechanics behind the protocols to practical how-tos and advanced strategies. Whether you're looking to earn interest on stablecoins, unlock liquidity without selling your assets, or build complex yield loops, this guide has you covered.

You’ll learn:

• How lending and borrowing in DeFi works
• The best platforms to use and how to evaluate them
• Step-by-step instructions for lending and borrowing securely
• How to manage risks, avoid liquidation, and protect your capital

Let’s dive into the world of decentralized finance – and how to put your crypto to work.

Understanding DeFi Lending and Borrowing Mechanics

Core Concepts Explained

Before you lend or borrow in DeFi, it’s essential to understand the mechanics that make these systems work. Unlike traditional finance, DeFi protocols rely entirely on smart contracts and collateral-based models to manage risk, maintain solvency, and ensure users can always access their funds – without needing to trust a middleman.

Let’s break down the core concepts that underpin DeFi lending and borrowing:

Overcollateralization: The Safety Net of DeFi

In DeFi, borrowers must deposit more value in collateral than they borrow. This is called overcollateralization, and it's what allows permissionless lending to function securely.

For example, on Aave or Compound, you might need to deposit $150 worth of ETH to borrow $100 of USDC. This cushion protects the protocol in case the value of your collateral drops – it ensures lenders can be paid back even if markets crash.

Overcollateralization helps:

• Prevent undercollateralized debt
• Protect against borrower defaults
• Keep protocols solvent without human intervention

However, it also introduces risks for borrowers – mainly liquidation – which we’ll cover next.

Interest Rate Models: Variable, Stable, Time-Based and User-Chosen.

DeFi protocols employ various mechanisms to determine borrowing costs and lending yields. Understanding these models is crucial for selecting the right platform for your strategy.

1. Variable Interest Rates

Platforms like Aave and Compound adjust interest rates based on supply and demand dynamics. As borrowing demand increases, so do the rates, incentivizing more liquidity provision.

• Pros: Responsive to market conditions; potentially lower rates during periods of low demand.
• Cons: Rates can spike unexpectedly during high demand, leading to unpredictability.

2. Stable (Fixed) Interest Rates

Some platforms, such as Aave, offer “stable” rates that provide more predictable borrowing costs. While not immutable, these rates are less susceptible to short-term market fluctuations.

• Pros: Greater predictability in repayment planning.
• Cons: May still adjust under extreme market conditions or protocol-specific events.

3. Time-Based Loans

Teller introduces a novel model where loans are structured around fixed durations rather than fluctuating interest rates. Borrowers agree to repay the loan within a set timeframe (e.g., 1–30 days), and as long as they meet this commitment, their collateral remains secure, unaffected by market volatility.

• Pros: Eliminates liquidation risk due to price fluctuations; predictable repayment schedule.
• Cons: Requires strict adherence to repayment timelines; potential for default if not managed properly.

4. User-Set Interest Rates

Liquity V2 introduces a new category of lending protocols where borrowers can set their own interest rates. Instead of relying on algorithmically determined rates or market-based utilization curves, users propose the rate they’re willing to pay—and compete with others for access to capital.

Borrowers offering lower rates are more likely to have their positions redeemed if the system needs to stabilize. This means there’s a trade-off between cheap borrowing and the risk of early repayment via redemption.

Pros:

• Greater control over loan terms and borrowing cost
• Enables dynamic, borrower-driven rate discovery

Cons:

• Requires active rate management to avoid redemptions
• Risk of being redeemed if rates are too low

This model shifts interest rate dynamics from protocol-level settings to borrower-driven markets, offering more flexibility but demanding more hands-on management.

🔍 Interest Rate Models Compared

Liquidation Risks and Thresholds

If your collateral drops below a certain value relative to your loan, the protocol will liquidate part or all of your position to repay the debt and maintain platform solvency.

Each protocol and asset has a liquidation threshold, usually expressed as a percentage. For example:

• A 75% threshold means your loan can be up to 75% of your collateral value.
• If the ratio exceeds this due to market swings, liquidation can occur.

Liquidation penalties (typically 5–15%) mean you could lose a portion of your assets – so managing risk is crucial.

Health Factors and Safety Margins

Protocols like Aave use a health factor to give users a real-time risk score of their position. This metric combines your loan-to-value (LTV) ratio and the asset's liquidation threshold into a single number:

• Health factor > 1.0 = safe
• Health factor < 1.0 = at risk of liquidation

To stay safe, it's recommended to borrow well below the maximum limit and maintain a healthy buffer – especially in volatile markets. Tools and dashboards can help monitor your health factor and alert you before it’s too late.

Types of Lending Protocols

DeFi lending isn’t one-size-fits-all. There are several categories of protocols, each with its own architecture, use cases, and risk profile. Understanding these distinctions will help you choose the right platform for your specific strategy – whether you’re lending stablecoins, unlocking liquidity from NFTs, or building a leveraged position.

Money Market Protocols (e.g., Aave, Compound)

Money markets are the most widely used lending protocols in DeFi. They operate as pooled liquidity platforms where users can deposit assets to earn interest or borrow against their collateral.

• Key features:
• Dynamic interest rates based on supply and demand
• Overcollateralized loans
• Support for multiple assets
• Integrated risk parameters per asset (loan-to-value ratio, liquidation threshold, etc.)

These protocols are ideal for both passive lenders seeking yield and active borrowers who want to access liquidity without selling their assets.

CDP Platforms (e.g., MakerDAO, Liquity V2)

Collateralized Debt Position (CDP) platforms enable users to lock up crypto assets as collateral to mint decentralized stablecoins. These platforms offer varying mechanisms and features:

MakerDAO

• Collateral: Supports multiple assets, including ETH and various ERC-20 tokens.
• Stablecoin: DAI, a decentralized stablecoin pegged to the US dollar.
• Mechanism: Users deposit collateral into “vaults” to generate DAI.
• Management: Requires active monitoring to maintain safe collateral ratios and avoid liquidation.
• Governance: Decisions on risk parameters and collateral types are made through a decentralized governance process.

Liquity V2

• Collateral: Accepts ETH and select Liquid Staking Tokens (LSTs) like wstETH and rETH.
• Stablecoin: BOLD, a USD-pegged stablecoin.
• Mechanism: Users open “Troves” by depositing collateral and minting BOLD.
• Interest Rates: Users set their own interest rates, introducing a market-driven approach.
• Stability Pools: Each collateral type has its own Stability Pool, where BOLD holders can deposit to earn yields from borrower interest payments and liquidation gains.
• Governance: The protocol is immutable with no governance, ensuring consistent rules and reducing attack vectors.

Liquity V2's innovative features, such as user-set interest rates and multiple Stability Pools, offer users greater control and potential for optimized borrowing and lending strategies.

NFT Lending Protocols

NFTs aren't just for art and PFPs – they can also be used as collateral to borrow crypto. NFT lending protocols help unlock liquidity from high-value non-fungible assets like CryptoPunks, Bored Apes, or game items without selling them.

There are two main models:

1. Peer-to-Peer Lending

Platforms like NFTfi and Arcade let lenders and borrowers negotiate loan terms directly. Lenders review collateral, propose interest rates and durations, and lock funds if both parties agree. If the borrower fails to repay, the lender can claim the NFT.

2. Pooled Lending (Peer-to-Protocol)

Platforms like JPEG’d or BendDAO use automated pricing oracles to determine NFT values and issue loans from a pooled liquidity fund. This allows faster and more scalable lending but comes with risks tied to oracle accuracy and NFT floor volatility.

NFT lending is ideal for:

• Unlocking liquidity without selling blue-chip NFTs
• Accessing leverage in NFT-heavy portfolios
• Yield farming with idle NFTs

Want to learn more?

👉 Check out our dedicated guide: NFT Lending: Accessing Liquidity Through Your NFTs

DeFi lending continues to evolve – from traditional token loans to unlocking capital from exotic assets. Matching the protocol type to your goals is key.

Key Metrics for Evaluating Lending Platforms

Before you lend or borrow in DeFi, it’s important to evaluate the platform you’re using. Even though everything is automated by smart contracts, not all protocols are created equal – and the risks can be very real.

As a beginner, the best approach is to stick with established, battle-tested platforms like Aave, Compound, or Maker. These have been running for years, hold billions in assets, and have strong security records. New protocols can be tempting with high interest rates, but they’re also riskier – especially if they haven’t been audited or widely used.

Here are the key things to look at:

Total Value Locked (TVL)

TVL refers to the total amount of assets currently deposited in a protocol. It’s a rough measure of trust and popularity.

• Why it matters: Higher TVL often means more liquidity, better interest rates, and stronger community confidence.
• Caution: Don’t rely on TVL alone. Some new protocols offer inflated incentives to attract capital temporarily.

You can check live TVL stats on platforms like DeFiLlama or DappRadar.

Security History & Smart Contract Audits

DeFi protocols rely on smart contracts, and if those have bugs, funds can be lost. That’s why audits and security practices matter.

• Look for: Public audits from reputable firms, time-tested code, and a history of fixing issues quickly.
• Avoid: Platforms with no audits, anonymous teams, or a history of exploits.

If you're unsure, search the protocol's name + “audit” or check DeFi safety aggregators like DeFiSafety.com.

Interest Rate Stability

Lending and borrowing rates change constantly, especially on smaller platforms with low liquidity.

• As a lender: You want rates that aren’t just high, but also stable enough to be worth your time.
• As a borrower: You want to avoid a loan that becomes too expensive overnight.

Established platforms tend to have deeper liquidity and smoother rate curves.

Liquidation Parameters

Each platform defines how much you can borrow against your collateral and how close you can get to liquidation.

• Important: Don’t borrow right up to the limit – leave a buffer. Price swings happen fast.
• Look for tools that show your “health factor” or loan safety score at a glance.

Insurance can’t protect against everything (like bad user decisions), but it adds a layer of protection in case of smart contract failure or protocol-wide issues.

🔒 Reminder for beginners:

The best way to stay safe is to use proven platforms. DeFi moves fast – but when your money’s on the line, slow and secure wins every time.

Preparing for DeFi Lending & Borrowing

Before you lend or borrow your first crypto asset, there are a few essential things to get in place. While DeFi platforms like Aave make the process relatively smooth, having the right setup and understanding a few basics will help you avoid costly mistakes.

This section walks you through how to prepare safely – whether you're lending stablecoins for yield or borrowing USDT using ETH as collateral.

1. Set Up a DeFi-Compatible Wallet

You’ll need a self-custodial wallet that works with DeFi apps. The two most popular options are:

• MetaMask – Beginner-friendly, widely supported
• 👉 MetaMask Wallet: Complete Setup Guide for DeFi
• Rabby Wallet – A newer alternative with built-in DeFi features
• 👉 Rabby Wallet: The MetaMask Alternative Built for DeFi

Once your wallet is installed, make sure it’s funded with some ETH (for gas fees and collateral) – even small amounts are fine to start.

2. Choose Your Assets

For this walkthrough, we’re using ETH as collateral and borrowing USDT. This combination is common in DeFi because:

• ETH is widely accepted as collateral
• USDT is a stablecoin, so you avoid price volatility on the borrowed side

Other popular collateral/loan pairs include wBTC/DAI, stETH/USDC, etc. But for first-timers, ETH + USDT is a simple and easy-to-track option.

3. Understand the Risks

DeFi loans are overcollateralized, meaning if the value of your collateral drops too much, you could be liquidated.

That’s why we always recommend:

• Only borrowing well below the max allowed limit
• Using small amounts until you’re comfortable
• Monitoring your health factor (more on that later)

4. Use a Trusted Platform

In this guide, we’ll use Aave – one of the most secure and battle-tested lending protocols in DeFi.

Why Aave?

• Billions in deposits
• Fully audited and transparent
• Beginner-friendly interface
• Supports ETH, USDT, and many other assets

Avoid lesser-known platforms for now. Stick to what’s proven.

Once your wallet is set up and funded, and you understand what you're doing, you're ready to lend or borrow your first assets in DeFi.

Step-by-Step: Borrowing on Aave Using ETH as Collateral

In this demonstration, we’ll borrow USDT using a small amount of ETH as collateral on Aave V3. The screenshots use Rabby Wallet, but the process is nearly identical with MetaMask.

We'll go step-by-step to keep things simple.

Step 1: Connect Your Wallet to Aave

To start, go to app.aave.com and follow these steps:

1. Click “Connect Wallet”

Look to the top right corner of the screen and click the Connect Wallet button.

2. Choose Your Wallet

A pop-up will appear with several wallet options. Select the one you’re using (Rabby or MetaMask are the most common).

In this example, we’re choosing Rabby Wallet.

3. Confirm the Connection

Your wallet will ask you to approve the connection. Review the site details and click Connect to continue.

Once your wallet is connected, you’ll be able to see your balances, supply and borrow options, and track your health factor.

✅ You’re now ready to deposit ETH as collateral and borrow USDT.

Step 2: Choose the Network (Arbitrum)

After connecting your wallet, the next step is selecting the Aave market (also known as an instance or network). Aave supports multiple blockchains, and each one has different assets, rates, and gas fees.

For this guide, we’re using Arbitrum One, a fast and low-cost Ethereum Layer 2 network.

4. Click the Instance Dropdown

At the top of the dashboard, you’ll see the current network selected (usually Core Instance by default). Click it to open the dropdown menu.

5. Select “Arbitrum” from the List

In the dropdown, scroll down and select Arbitrum under the “Version 3” tab. The interface will reload, showing assets and markets available on Arbitrum.

✅ You’ve now selected the Arbitrum network. You’ll be supplying ETH and borrowing USDT on this network – with lower fees than Ethereum mainnet.

Step 3: Deposit ETH as Collateral

To borrow USDT on Aave, you first need to deposit ETH as collateral. This means locking up ETH in the protocol, which enables you to take out a loan against it.

In this guide, we’re depositing a small amount of ETH (~$10) to demonstrate how it works safely.

6. Click “Supply” Next to ETH

Under the “Assets to supply” section, locate ETH. If you have ETH in your wallet, it will show the available balance. Click Supply.

7. Enter the Amount and Confirm Supply

In the popup window, enter how much ETH you want to deposit. For this example, we’re using 0.004 ETH (about $10). Make sure Collateralization is enabled (you’ll see a green check).

Click Supply ETH.

8. Sign the Transaction

Your wallet will ask you to approve the transaction. Review the details, then click Sign (or Confirm, depending on wallet).

All Done: Deposit Confirmed

Once the transaction is complete, you’ll see a confirmation. Your ETH is now deposited and ready to be used as collateral.

You can optionally click “Add to Wallet” to track the deposit token (aToken) in your wallet – this isn’t required but can be useful for advanced DeFi use.

You’re now ready to borrow against your ETH!

Step 4: Borrow USDT Against Your ETH Collateral

Now that you’ve deposited ETH, you can use it as collateral to borrow a stablecoin. In this guide, we’ll borrow 4 USDT (technically labeled as USD₮₀ on Aave Arbitrum).

This is a safe, small example that avoids liquidation risks while demonstrating the full borrowing process.

10. Click “Borrow” Next to USDT

Under “Assets to borrow,” find USD₮₀ and click the Borrow button.

11. Set Borrow Amount and Review Health Factor

A window will open to set how much USDT you want to borrow. In this guide, we’re borrowing 4 USDT. Below, you'll see your health factor – a key metric that shows how safe your position is. Keep it well above 1.0 (we're at 2.13, which is very safe).

Click Borrow USD₮₀.

12. Sign the Transaction

Your wallet will prompt you to approve the borrow transaction. Check the gas fee and click Sign.

Borrow Confirmed

That’s it – you’ve successfully borrowed USDT! You’ll see a confirmation screen and can optionally click “Add to Wallet” to make the USDT token visible in your wallet.

Your dashboard will now show:

• Your borrowed amount
• Your health factor (keep an eye on this!)
• Options to repay, add collateral, or switch rates

Step 5: Monitor Your Position and Stay Safe

After borrowing USDT, your DeFi position becomes dynamic. Prices move, rates change, and your health factor may fluctuate. This step shows you how to stay on top of your loan and avoid liquidation.

Check Your Health Factor on Aave

Your health factor tells you how close your loan is to liquidation. The higher, the safer.

• Above 2.0 = Safe
• Below 1.5 = Getting risky
• Below 1.0 = Liquidation risk

You can view it right in Aave’s dashboard, along with your net worth, debt, and collateral.

Understand Liquidation Parameters

Clicking on the health factor opens a detailed breakdown of:

• Current LTV (Loan to Value)
• Liquidation threshold
• How much buffer you have

This visualization helps you decide when to repay or add collateral.

Use External Dashboards (Optional but Helpful)

To monitor across multiple platforms, tools like DeBank and Zapper give a cleaner overview of your positions.

• DeBank shows your supplied/borrowed assets, health score, and network.

• Zapper gives a quick portfolio overview and visualizes your debt and supplied tokens.

Summary

At this point, you’ve:

• Deposited ETH as collateral
• Borrowed USDT safely
• Learned how to track your health factor
• Explored tools for ongoing monitoring

You’re now actively participating in DeFi lending and borrowing like a pro.

Switching Collateral or Borrowed Asset

Eventually, you might want to adjust your position without fully repaying your loan. Maybe you’d prefer to use a different asset as collateral, or you want to switch your borrowed token to one with a lower interest rate or better utility. Aave makes this possible through the Switch function.

Let’s walk through both use cases.

Switching Collateral (e.g., from ETH to WBTC)

If you want to use a different asset as collateral (for example, switching from ETH to WBTC), you can do so without unwinding your whole position.

Here’s how to do it:

1. Click the “Switch” button in the “Your Supplies” section next to your current collateral.
2. A modal will open. Choose the asset you want to switch to. In this example, it’s WBTC.
3. Review the updated stats, including health factor, supply APY, and liquidation threshold.
4. If everything looks good, click “Approve to continue” and sign the message with your wallet.
5. Once approved, finalize the switch by confirming the transaction.

📸 See below:

Keep in mind that changing collateral may lower or raise your liquidation threshold and alter your health factor.

Switching Borrowed Asset (e.g., from USDT to GHO)

You may also want to switch your debt position to another stablecoin or token with a better borrow rate or protocol incentives.

Here’s how to do it:

1. Click “Switch” next to your current borrowed asset under the “Your Borrows” section.
2. A modal will appear. Select the asset you’d like to switch your loan into (e.g., GHO).
3. Review the impact on your borrow APY, balance after switch, and slippage tolerance.
4. Click “Approve to continue” and sign the message.
5. After approval, confirm the final switch transaction in your wallet.

📸 See below:

This lets you take advantage of shifting market conditions or protocol incentives without needing to repay and re-borrow manually.

Aave Market Parameters: How to Interpret Protocol Metrics

Understanding the broader market parameters in Aave gives you important context about asset utilization, interest rate volatility, reserve liquidity, and risk thresholds. These numbers help you make smarter decisions when supplying or borrowing assets-especially when market conditions change quickly.

1. Market Overview

From the Aave market overview, you can see the total value supplied and borrowed for each asset, along with the current supply APY and borrow APY. These rates are dynamic and respond to market activity and asset utilization.

This snapshot helps you:

• Compare yields across assets before supplying.
• Understand which assets are heavily borrowed (which may lead to higher interest).
• Identify potential opportunities where utilization is low but borrow demand might increase.

2. Supply-Side Configuration

When you click into a specific asset (like WETH), you get detailed reserve parameters:

• Utilization Rate – how much of the asset pool is currently borrowed (76.58% here).
• Max LTV (Loan-To-Value) – how much value you can borrow against the asset (80% for WETH).
• Liquidation Threshold – if your collateral ratio drops below 84%, your position may be liquidated.
• Liquidation Penalty – the discount given to liquidators (5% in this case).

This page is critical if you're planning to use the asset as collateral.

3. Borrowing Metrics

On the borrowing side, the APY (variable) tells you the current interest rate to borrow the asset. More importantly, the Borrow Cap tells you how much liquidity remains available.

• When utilization gets close to 100%, borrowing becomes more expensive.
• The Reserve Factor (here 15%) indicates how much of the interest paid goes to Aave's safety module.

This information helps gauge how crowded the borrow side of a market is-and if interest rates may spike soon.

4. E-Mode & Interest Rate Model

Assets like WETH can be grouped in E-Mode (Efficiency Mode), which offers:

• Higher LTV: Up to 93%
• Tighter Liquidation Thresholds: 95% instead of 84%
• Lower Liquidation Penalties: 1%

E-Mode is intended for correlated assets (like ETH and stETH), letting you borrow more safely within the same category.

Below that, the interest rate model chart shows how borrow rates sharply rise when utilization crosses a certain threshold (e.g., 90%). This protects protocol solvency and incentivizes repayment during stress.

💡 Tip:

• If you’re borrowing large amounts or relying on volatile collateral, always check this section first. It only takes a minute, but it can save you from surprises down the line.

Repaying the Loan on Aave

Eventually, you’ll want to close your position-either to take profits, reduce your risk, or move assets elsewhere. Let’s walk through how to repay your loan on Aave and understand what happens when you do.

This example covers how to repay using your wallet balance, which is the most common method. You can also repay using your supplied collateral, but we’ll stick to the simpler flow here.

Step 1: Initiate the Repayment

Head to the Your Borrows section on the Aave dashboard. Locate the asset you've borrowed (in this case, USDT₮0) and click the Repay button.

Step 2: Choose Repayment Source and Amount

A popup will appear.

• Under Repay with, choose Wallet balance
• Enter the amount to repay (you can repay partially or fully)
• Click Approve [Token] to continue – this grants permission to Aave to pull that token from your wallet

Step 3: Sign the Permit Approval

If your token supports permit approvals (like USDT on Aave), your wallet will request a signature instead of a separate gas-heavy approval transaction.

• This is safe and standard
• Review and sign the message

Step 4: Confirm the Repayment Transaction

Once the approval is signed, the Repay button becomes active.

• Click Repay
• Your wallet will now request a final signature to complete the repayment

Step 5: Success! Loan Repaid

Once the transaction goes through, Aave will show a confirmation message.

• Your borrow balance will reset to $0
• Your health factor will rise, as you now have no debt

What Happens Next?

• Your collateral remains supplied to Aave, still earning interest
• You can now choose to withdraw it at any time
• If you plan to exit completely, go to the Your Supplies section and click Withdraw

Tips:

• Repaying early saves you from accruing more interest
• You don’t need to repay everything at once-you can pay in parts
• If you repay using collateral, your total supply balance will decrease proportionally

Summary: Unlocking the Power of DeFi Lending and Borrowing

Lending and borrowing are two of the most powerful building blocks in DeFi.

You’ve now seen the full process:

• Supplying ETH as collateral
• Borrowing stablecoins like USDT
• Managing your position and monitoring risk
• And eventually, repaying the loan

Platforms like Aave make this possible with no banks, no credit checks, and no intermediaries – just smart contracts and your wallet.

But this freedom comes with responsibility. Risk management is key. Understanding your health factor, liquidation thresholds, and interest rate dynamics will help you stay safe and make better decisions.

Whether you’re borrowing to access liquidity, hedge exposure, or deploy more capital into DeFi, you're now equipped with the knowledge to do it right.

🔁 What’s Next?

If you’re ready to dive deeper:

• Learn how to loop stablecoin strategies to amplify yields
• Explore E-Mode to unlock more capital efficiency

👉 Explore more Unleash DeFi guides »

FAQs (Frequently Asked Questions)