Lending Mechanics in Depth
A DeFi loan has no credit check — just collateral worth more than the loan, and a tripwire that sells it if the cushion thins.
You met DeFi lending back in lesson 13: deposit crypto, borrow against it, no bank. But a bank at least checks who you are. A smart contract can’t — it has never met you and can’t chase you if you vanish. So how does it dare hand you a loan? The answer is a set of gears — collateral, a health number, and an automatic tripwire — that replace trust in you with math anyone can check. Hold the question: if the code can’t trust the borrower, what must it trust instead?
Over-collateralization: post more than you borrow
The core trick is over-collateralization: to borrow $100, you must lock up more than $100 of crypto — say $150. Since the contract can’t trust you, it holds hostage something worth more than the loan. If you never repay, it keeps (well, sells) your collateral and comes out whole. This is why “DeFi lending” isn’t like a bank loan for someone with no money — you already need assets. What it does let you do is borrow against holdings without selling them (e.g., borrow stablecoins against your ETH).
Loan-to-value and the health factor
Two numbers run the show. Loan-to-value (LTV) is how much you’ve borrowed versus your collateral’s value — borrow $100 against $150 and your LTV is 67%. Each collateral type has a maximum LTV it’s allowed to reach. The health factor is just how far you are from that limit: comfortably above it and you’re safe; drift up to it and you’re in danger. Crucially, LTV moves on its own — if your collateral’s price falls, the same loan is now a bigger fraction of a smaller cushion, and your health factor drops even though you did nothing.
A cushion thinning on its own: • You lock $150 of ETH, borrow $100 of stablecoin → LTV 67%. Max allowed LTV is 80%. Healthy. • ETH drops 20%: your collateral is now worth $120, but the loan is still $100 → LTV 83%. • You’ve crossed the 80% limit without lifting a finger — and that’s exactly when the tripwire fires.
Interest from utilization, and the liquidation tripwire
Two more gears. Interest rates float with utilization: a pool that’s mostly lent out (little spare to borrow) charges high rates to attract deposits and discourage borrowing; a pool sitting idle charges little. Nobody sets the rate by hand — supply and demand do, transparently. And when a loan’s health factor crosses the line, anyone can trigger a liquidation: a third party repays part of your loan and takes your collateral at a discount as their reward. It’s automatic and permissionless — the contract doesn’t wait for a manager’s approval. Watching your health factor isn’t optional; it’s the whole job of a DeFi borrower.
It’s a pawn shop run by a robot. You want $100, so you hand over a watch worth $150 — the robot never asks your name because it’s holding something worth more than the loan. Painted on the counter is a rule: “if the watch’s resale value ever dips below $125, I sell it immediately.” The robot doesn’t care why the price fell; it just watches the number. Your only job is to keep the watch’s value comfortably above the line — top it up or repay before the robot pulls the trigger, because it shows no mercy and needs no permission.
A liquidation, step by step: 1. You borrow $5,000 of stablecoin against $8,000 of ETH (LTV 62.5%, max 80%). 2. A market drop cuts ETH to $6,000 → LTV 83%, health factor below 1. You’re underwater on the rules. 3. A liquidator bot instantly repays part of your loan and seizes an equivalent chunk of your ETH plus a bonus (say 5–10%) as its incentive. 4. Your debt shrinks and your collateral shrinks more — you keep the borrowed cash but lost value to the penalty. The fix was to add collateral or repay before the price hit the line.
This is the reading. The interactive version — active-recall quiz, a hands-on experiment you run in your own AI, and an earned mastery check — is free in the app.
Start this lesson free →