Aave is a well-known DeFi protocol that enables lending and borrowing without a bank. People can deposit crypto to make it available for others to borrow, while borrowers take out loans by locking up their own crypto as collateral, all handled automatically by smart contracts.
That description is accurate but it skips the part that actually matters: why anyone would borrow money they already have, and what happens when the market moves against them. Both of those follow from a single design constraint, and understanding it explains most of DeFi lending.
The constraint everything else follows from
A bank lends against your identity. It checks your income, your credit history, and your legal obligation to repay. If you default, it can pursue you.
A smart contract knows none of that. It cannot check who you are, cannot sue you, and cannot recover anything you do not hand it in advance.
So it uses the only enforcement mechanism available: it holds more of your money than it lends you. If you disappear, the protocol keeps the collateral and nobody is out of pocket.
This is called over-collateralisation, and it is the reason DeFi lending looks strange to anyone coming from traditional finance.
How the two sides work
Supplying. You deposit an asset into a pool. Borrowers draw from that pool and pay interest, and that interest is distributed to suppliers. You can withdraw whenever there is enough unborrowed liquidity in the pool to cover it.
Borrowing. You lock collateral and take out a different asset against it. There is no repayment schedule and no fixed term. Interest accrues continuously, and you repay whenever you choose — as long as your position stays healthy.
Both sides are handled by code. No application, no approval, no counterparty deciding whether to lend to you.
Why borrow money you already have
This is the question that stops most beginners, and the answer is that the borrower does not want the money — they want to keep the collateral.
Someone holding ETH who needs dollars has two options. Sell the ETH, or borrow against it. Selling means giving up the position entirely. Borrowing means keeping it while accessing liquidity now.
Other common reasons include accessing funds without triggering a taxable disposal in some jurisdictions, and using borrowed assets in other protocols.
All of these amplify exposure rather than reduce it. Borrowing against a volatile asset means you are now exposed to that asset's price twice — once as the thing you hold, and once as the thing that determines whether your loan survives.
Health factor, with real numbers
Aave measures every position with a single number called the health factor:
Health Factor = (Collateral Value × Liquidation Threshold) ÷ Borrowed Value
The liquidation threshold is set per asset by Aave governance. For ETH it has typically been around 80 percent.
A worked example:
| You deposit | $15,000 of ETH |
| Liquidation threshold | 80% |
| You borrow | $10,000 of USDC |
| Health factor | ($15,000 × 0.8) ÷ $10,000 = 1.2 |
Now ETH falls 20 percent:
| Collateral now worth | $12,000 |
| Health factor | ($12,000 × 0.8) ÷ $10,000 = 0.96 |
Below 1.0, the position is eligible for liquidation.
Notice what happened. ETH fell 20 percent and the position went from comfortable to liquidatable. Crypto assets move 20 percent in a day with some regularity.
What liquidation actually looks like
This is where DeFi differs most sharply from traditional margin lending, and it is the part worth internalising before anything else.
There is no margin call. No email, no phone call, no grace period, no human deciding to give you until Monday.
When the health factor crosses 1.0, external liquidators — usually automated bots — can repay part of your debt and take your collateral at a discount. That discount is their profit and it comes out of your position. The whole thing executes in a single block, often within seconds of the price update that triggered it.
Under Aave V3, up to 50 percent of the debt can be liquidated in one transaction when the health factor is above 0.95 and both collateral and debt exceed roughly $2,000. Below that, a larger portion can be taken.
You do not get a warning. You get a smaller position.
How much buffer people actually keep
Published risk monitoring gives a sense of how differently people treat this.
A review of Aave V3 in July 2026 found the top twenty USDT borrowers running health factors between 1.01 and 2.03, with a median around 1.30. Separate monitoring the same month flagged large wallets running leveraged stablecoin strategies at health factors near 1.02 and 1.03.
A position at 1.02 survives a roughly two percent adverse move. That is not a strategy for an individual — it is a professional operation with real-time alerts and automated repayment, betting that it can react faster than the market.
Common guidance among DeFi risk tools is to treat 1.5 and above as comfortable, 1.1 to 1.5 as requiring active monitoring, and below 1.1 as demanding immediate action. Those are conventions rather than rules, and none of them make a position safe.
Interest rates move on their own
Rates on Aave are not set by anyone. They are calculated from utilisation — the proportion of a pool currently borrowed.
When little is borrowed, rates are low, which encourages borrowing. As utilisation climbs toward the pool's optimum, rates rise steeply, which encourages repayment and discourages new loans. This keeps liquidity available for suppliers who want to withdraw.
The practical consequence for a borrower is that your cost is not fixed. A loan that is cheap today can become expensive if demand for that asset rises, and this happens without warning or notice.
The risks, stated plainly
Liquidation. The most common way people lose money here. It is automatic, fast, and offers no recourse.
Smart contract risk. The protocol is code. Audits reduce the chance of a flaw but do not eliminate it, and DeFi history contains many exploits of audited contracts.
Oracle risk. Liquidations trigger on prices supplied by oracles. If an oracle reports a wrong price, positions can be liquidated that should not have been.
Governance risk. Aave's DAO can change risk parameters, including liquidation thresholds. A parameter change can move your health factor without you doing anything.
Correlated collapse. Risk models often assume assets move independently. In a sharp crypto sell-off most assets fall together, which means diversified collateral offers less protection than the maths suggests.
Interest rate risk. Variable rates can rise substantially.
Flash loans: the exception
Aave also supports flash loans, which appear to break the over-collateralisation rule — they require no collateral at all.
They do not break it. A flash loan must be borrowed and repaid inside a single transaction. If repayment does not happen, the entire transaction reverses as though it never occurred, so the lender is never at risk.
This makes them a developer tool rather than a consumer product. They are covered in their own entry.
Common misconceptions
"It is a loan, so I get money I did not have." You get liquidity while keeping an asset, in exchange for locking up more than you receive. Your total exposure goes up, not down.
"I will get a warning before liquidation." You will not. Liquidations execute automatically the moment the health factor crosses 1.0.
"A health factor above 1 means I am safe." It means you are not currently liquidatable. At 1.05, a five percent move changes that.
"No credit check means anyone can borrow." Anyone with sufficient collateral can borrow. The collateral requirement is the credit check.
"Audited means safe." Audits reduce risk. They do not remove it, and audited protocols have been exploited.
What to take from this
DeFi lending replaces trust in an institution with a mechanical rule: hold more collateral than you borrow, or lose it automatically.
That trade is neither better nor worse than a bank — it is different. There is no discretion, no negotiation, and no bad day taken into account. The rule executes regardless of circumstance.
Understanding that is what lets you evaluate any lending protocol, including ones that do not exist yet. The specific numbers change. The structure does not.
This entry explains what Aave is and how DeFi lending works through it. It is educational. Using such protocols carries real risks, including smart contract flaws and liquidations, and nothing here recommends lending, borrowing, or holding any asset. Parameters described reflect published documentation as of August 2026 and are subject to governance changes.