Crypto lending and borrowing: collateral, health factor and liquidations
Borrowing without a bank means borrowing against collateral that a smart contract can sell. Here's exactly when it does.
In DeFi lending, lenders deposit tokens into a pool and borrowers take loans only against collateral worth more than the loan. A health factor (collateral value × collateral factor ÷ debt) tracks safety: if it falls below 1, liquidators repay part of the loan and take your collateral plus a bonus. Interest rates float with how much of the pool is borrowed.
How DeFi lending works
A lending protocol such as Aave is a set of smart contracts holding pools of tokens. Lenders deposit tokens into a pool and earn interest. Borrowers take tokens out of the pool, but only after depositing collateral worth more than the loan. There's no credit check and no one deciding: the contract checks the collateral and lends instantly.
Why loans are overcollateralized
The protocol doesn't know who you are and can't chase you for repayment, so the only protection for lenders is collateral it can sell. Each collateral token gets a limit on how much of its value can be borrowed against (the loan-to-value or collateral factor): perhaps 70% to 80% for ETH, less for riskier tokens, nothing for some. To borrow $6,000 you might lock up $10,000 of ETH. Why borrow at all, then? Mostly to get cash without selling (which in many countries would be a taxable sale), or to use leverage.
The health factor
Aave sums up each position in one number:
Health factor = (collateral value × collateral factor) ÷ debt value
Above 1, the position is safe. Below 1, it can be liquidated. Aave's own example: $10,000 of ETH with an 80% factor backing a $6,000 loan gives 10,000 × 0.8 ÷ 6,000 = 1.33. (Aave version 3 calls the factor used here the liquidation threshold; version 4, launched on Ethereum in March 2026, calls it the collateral factor.)
Worked example: your liquidation price
You deposit 5 ETH at $2,000 ($10,000) with an 80% factor, and borrow $6,000 of USDC. Your health factor is 5 × $2,000 × 0.8 ÷ $6,000 = 1.33.
The health factor hits 1 when the collateral's price falls to debt ÷ (amount × factor) = $6,000 ÷ (5 × 0.8) = $1,500, a 25.0% drop. Interest keeps adding to the debt, so that price creeps up over time unless you repay or add collateral.
What a liquidation is
When a position's health factor falls below 1, anyone can act as a liquidator: they repay part of the debt and receive the same value of your collateral plus a bonus, typically a few percent. You keep the borrowed money, but you lose collateral worth more than the debt that was repaid, so a liquidation always costs you. In a crash, thousands of positions are liquidated at once, and liquidators selling the seized collateral can push prices down further.
If prices fall so fast that collateral is worth less than the debt before liquidators act, the protocol is left with bad debt that lenders may have to absorb. In April 2026, after an exploit of KelpDAO's rsETH bridge, Aave was left with an estimated $124–230 million of bad debt (LlamaRisk); it froze the affected markets, and lenders in some pools couldn't withdraw while utilization sat at 100%.
How interest rates are set
Rates float with utilization: the share of a pool that's been borrowed. When little is borrowed, rates are low. As utilization rises, rates climb, and above a set "optimal" level (chosen per token by governance; for major stablecoins it's typically around 80–90%) they jump sharply to attract deposits and discourage borrowing. That protects lenders' ability to withdraw, but at 100% utilization lenders may have to wait to get their money back.
The risks
- Liquidation if your collateral falls, which can happen in minutes in a crash.
- Bad debt and frozen withdrawals for lenders after hacks or sudden crashes.
- Smart-contract and oracle risk: a bug, or a wrong price feed, can trigger losses or wrongful liquidations.
- Collateral risk: exotic collateral tokens (bridged, restaked or wrapped) carry their own hacks and depegs.
- No safety net: no deposit insurance, no hardship plans, no customer service. Compare the collapse of centralized crypto lender Celsius in 2022: different structure, same lesson.
Related reading: Oracles: getting real-world data onto a blockchain · Liquid staking and restaking explained · Smart contract exploits and bridge hacks
Frequently asked questions
What is a health factor in DeFi?
A single number showing how safe a loan is: the borrowing value of your collateral divided by your debt. Below 1, the position can be liquidated.
How do I calculate my liquidation price?
For one collateral token and a stablecoin loan: liquidation price = debt ÷ (collateral amount × collateral factor). For example, $6,000 ÷ (5 ETH × 0.8) = $1,500 per ETH.
Why do DeFi loans require more collateral than the loan?
The protocol can't check credit or pursue borrowers, so collateral that can be sold automatically is the lenders' only protection.
What happens to my loan in a liquidation?
A liquidator repays part of your debt and takes collateral worth that amount plus a bonus. You keep the borrowed tokens but end up with less collateral than the debt reduction justifies.
Is lending crypto in DeFi safe?
It carries real risks: hacks, bad debt from crashes, oracle failures and frozen withdrawals. Rates that look like a savings account are paying you for those risks.
Where to next
Sources
- Positions and health factor (Aave V4 documentation)
- Liquidations (Aave documentation)
- Aave V4 launch explained (Bitcoin.com News, March 30, 2026)
- The KelpDAO/LayerZero exploit and DeFi (Galaxy Research, April 2026)
- Decentralized finance (ethereum.org)
Written for beginners and checked against the sources listed. Last reviewed November 5, 2026. This page is educational and is not financial, tax or legal advice. How we write and check pages.