DeFi Lending Explained: Collateral, Health Factor, Liquidation
Lesson 5 of 10 · Intermediate
How does lending work in DeFi?
DeFi lending protocols (such as Aave and similar ones) are markets where one group deposits assets to earn interest and another group borrows against collateral. Because the protocol does not know you and cannot go to court if you fail to repay, almost all loans are over-collateralised: the value of your collateral must exceed the loan.
Interest rates are usually variable and depend on the utilisation rate: the larger the share of deposited assets that has been borrowed, the higher the rate for both sides. When utilisation approaches 100 percent, depositors may be temporarily unable to withdraw, because their money is in borrowers’ hands. This liquidity risk is often overlooked by people who look only at the “deposit yield”.
Three key numbers: LTV, liquidation threshold and health factor
- Maximum LTV (loan-to-value): the highest percentage of your collateral’s value that you can borrow.
- Liquidation threshold: the percentage of collateral value above which, if your debt rises past it, the position can be liquidated. It is usually slightly higher than maximum LTV.
- Health factor: (collateral value × liquidation threshold) ÷ debt value. Above 1 is safe; below 1 means liquidatable.
Hypothetical example: you post 10 ETH at a hypothetical price of 3,000 dollars (30,000 dollars) as collateral. Suppose maximum LTV is 75 percent and the liquidation threshold is 80 percent. So you can borrow at most 22,500 dollars. You act more cautiously and borrow 15,000 dollars of stablecoins.
- Health factor: (30,000 × 0.8) ÷ 15,000 = 1.6
- Liquidation price: where 10 × price × 0.8 = 15,000, which is about 1,875 dollars, roughly 37 percent below the current price.
- Had you borrowed the maximum 22,500 dollars, the health factor would have been 1.07 and a drop of about 6 percent would be enough to be liquidated.
Remember that debt accrues interest and grows over time, so the health factor slowly declines even without any price change.
How liquidation works and what the penalty is
When the health factor falls below 1, anyone (usually bots) can repay part of your debt and in exchange take the equivalent from your collateral plus a liquidation bonus (a hypothetical 5 percent, say). That bonus is a penalty to you. In a volatile market, several liquidations in a row can take a large share of your collateral.
Unlike on a centralised exchange, there is no margin call or grace period. The price is set by an oracle, not by the price you see on your favourite exchange. If the oracle gives a wrong or delayed price, you may be liquidated unfairly or, conversely, liquidation may not happen in time.
One common high-risk pattern is the leverage loop (looping): you post collateral, borrow, use the borrowed money to buy more of the same asset and post it again. Apparent yield rises, but the distance to liquidation shrinks, and one sharp move unwinds the whole chain.
Bad debt: when liquidation is not enough
Bad debt arises when collateral value falls below the debt and liquidators have no incentive or ability to settle it. Common causes: a very fast price crash, thin market liquidity for the collateral, or collateral whose real value suddenly became zero or unknown. Bad debt ends up imposed on the protocol’s depositors, its reserve fund or governance token holders.
The Aave case after the rsETH hack: according to CoinDesk and Chainalysis, in April 2026 the protocol Kelp DAO suffered a hack of about 292 million dollars and its rsETH token was left on various chains without reliable backing. rsETH was accepted as collateral in lending markets. According to those reports, Aave faced about 195 million dollars of bad debt. The main lesson: a depositor in a lending market takes on the risk of every collateral that market accepts, even if the depositor holds only stablecoins.
The Stream Finance case in November 2025 is another example: according to Pharos, some lending vaults treated the xUSD token as a fixed 1 dollar while its real value had collapsed. When the oracle does not show reality, liquidation does not work either.
What to ask before borrowing or depositing
- Where is my liquidation price? Compare it with the worst historical drops of the collateral asset, not with average volatility. In crypto, falls of tens of percent within hours have happened.
- Where does this market’s oracle get its price? From how many sources and with what delay? Is a fixed price assumed for derivative tokens?
- What collateral does this market accept? If you are a depositor, the weakest accepted collateral is your risk.
- What if utilisation hits 100 percent? Do I need this money in the short term?
- What is my plan for a price drop? Repaying part of the loan or adding collateral should be decided in advance, not mid-volatility with high network fees.
These questions are not a substitute for financial advice; they only show where risk hides.
Common mistakes
- Borrowing close to the maximum LTV; a small price move is enough for liquidation.
- Forgetting that interest on debt lowers the health factor over time.
- Assuming a stablecoin deposit in a lending protocol is risk-free; bad debt from other collateral reaches depositors too.
- Ignoring the risk of high utilisation, which can make withdrawals temporarily impossible.
- Building leverage loops for extra yield without computing the final liquidation price.
- Trusting the price you see on an exchange instead of the price the protocol’s oracle uses.
What do volume and data say here?
Lending markets are fully transparent and you can monitor the state yourself:
- Utilisation rate: if an asset’s utilisation is near 100 percent, withdrawals may be slow or temporarily impossible. A sudden rise is often a sign of stress.
- Collateral mix: see which tokens the market accepts as collateral and in what share. A large share of an illiquid or derivative token (such as restaking tokens) is concentrated risk.
- Liquidation dashboards: some tools show the volume of collateral exposed to liquidation at each price. It resembles a liquidation map in futures: an estimate of vulnerable points, not a price magnet.
- Actual liquidation events: the volume of liquidations carried out on-chain shows where leverage has been flushed from the system.
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Frequently asked questions
How does lending work in DeFi?
You post an asset as collateral in a smart contract and borrow less than its value. If the collateral’s value falls below a set threshold relative to the debt, part of it is liquidated with a penalty.
What is the health factor?
A number computed as collateral value times the liquidation threshold, divided by debt value. Above 1 the position is currently safe; below 1 it can be liquidated.
What does bad debt mean in DeFi?
It is when collateral value falls below the debt and liquidation cannot cover the gap. The shortfall usually falls on depositors or the protocol’s reserve, as in the reports of Aave bad debt after the rsETH hack in April 2026.
Education only, not a recommendation to buy or sell; we never give signals. Price examples are illustrative. Test any method on a demo account first, with strict risk management.