DeFiIntermediate

Understanding DeFi Lending and Borrowing

How DeFi lending protocols let people lend and borrow crypto through smart contracts, and why over-collateralization matters.

6 min readPublished 2026-09-21

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Lending and borrowing without a bank
Why over-collateralization is the norm
How liquidation protects the protocol
Interest rates adjust automatically
What to remember

Key takeaways

What to remember

DeFi lending and borrowing is coordinated through smart contracts, not a traditional institution.
Loans are typically over-collateralized, since protocols generally don't perform credit checks.
Falling collateral value can trigger automatic liquidation, usually with a penalty.
Interest rates often adjust automatically based on supply and demand within the protocol.

Lending and borrowing without a bank

DeFi lending protocols let people supply crypto to earn interest, or borrow crypto against collateral, with the process coordinated automatically by smart contracts rather than a traditional financial institution.

Why over-collateralization is the norm

Because DeFi lending protocols generally don't perform credit checks, borrowers typically must post collateral worth more than the loan itself. This over-collateralization protects the protocol if the collateral's value drops before the loan is repaid.

How liquidation protects the protocol

If a loan's collateral value falls too close to the value of the loan itself, the position can be automatically liquidated: the collateral is sold to repay the loan, usually along with a liquidation penalty for the borrower.

The same sequence behind any liquidation: collateral is posted, its value falls, a maintenance threshold is crossed, and the position is forcibly closed -- usually with a penalty.

Interest rates adjust automatically

Rates on DeFi lending protocols often adjust automatically based on supply and demand for each specific asset within the protocol, rather than being set by a central decision-maker.

Why it matters

Monitor your loan's health, not just the moment you borrowed

A loan that starts safely collateralized can become at risk of liquidation if the collateral's price drops. Actively monitoring a loan's health ratio, rather than checking only once at the start, is an important practical habit for anyone borrowing in DeFi.

What to remember

DeFi lending and borrowing is coordinated through smart contracts, not a traditional institution.
Loans are typically over-collateralized, since protocols generally don't perform credit checks.
Falling collateral value can trigger automatic liquidation, usually with a penalty.
Interest rates often adjust automatically based on supply and demand within the protocol.