In traditional finance, getting a loan requires a credit check, income verification, and approval from a lending institution. On-chain lending works differently. There is no credit check and no application process. You deposit collateral, and the protocol lets you borrow against it automatically. Everything is managed by smart contracts.

How on-chain lending works

On-chain lending platforms like Aave and Compound operate as two-sided marketplaces. One side deposits assets to earn yield (the lenders). The other side deposits collateral and borrows against it (the borrowers). Smart contracts manage the entire process, including interest rate calculations, collateral requirements, and liquidation rules.

To borrow, you deposit crypto as collateral and receive a loan in a different asset, typically a stablecoin. The amount you can borrow depends on the value of your collateral and the platform's loan-to-value (LTV) ratio for that asset. If the LTV for ETH is 80%, depositing $10,000 worth of ETH allows you to borrow up to $8,000 in stablecoins.

You pay interest on the borrowed amount for as long as the loan is open. There is no fixed repayment date. You close the loan whenever you want by repaying the borrowed amount plus accrued interest, at which point your collateral is returned.

Why traders borrow

Borrowing against crypto lets you access liquidity without selling your holdings. If you hold ETH and expect its value to increase, selling it to fund another trade means giving up that upside. Borrowing against it lets you keep the ETH exposure while freeing up stablecoins for other trades or expenses.

Traders also use borrowing for leverage. Deposit ETH, borrow stablecoins, use those stablecoins to buy more ETH, and deposit the newly purchased ETH as additional collateral. This loop amplifies your exposure to ETH's price movement. It also amplifies your losses if ETH's price drops, so it requires careful risk management.

Collateralization ratios and health factors

Every lending position has a health factor that measures how safe your loan is relative to the value of your collateral. A health factor above 1 means your collateral is worth enough to cover the loan. As the health factor approaches 1, your position gets closer to liquidation.

Collateral requirements exist because crypto prices are volatile. A borrower who deposits $10,000 in ETH and borrows $8,000 has thin margin if ETH's price drops. The platform needs enough collateral headroom to remain solvent even if prices move sharply.

Most experienced borrowers maintain conservative LTV ratios well below the maximum. Borrowing only 50% of your collateral value instead of 80% gives you substantially more room to absorb price declines before facing liquidation.

How liquidation works

If the value of your collateral drops below the platform's liquidation threshold, part or all of your collateral gets sold automatically to repay the loan. This process is called liquidation, and it happens without warning or negotiation.

For example, if you deposited $10,000 in ETH and borrowed $8,000, a 25% drop in ETH's price reduces your collateral value to $7,500, which is now less than your loan amount. The platform liquidates your collateral to cover the debt, and you may receive little or nothing back after fees.

Liquidation events often cascade. When a large number of borrowers get liquidated simultaneously during a market downturn, the forced selling of collateral pushes prices down further, triggering more liquidations. This feedback loop has caused some of the sharpest single-day price drops in crypto history.

Interest rates

Interest rates on lending platforms are determined algorithmically based on utilization, which measures how much of the deposited supply is currently being borrowed. When utilization is low (lots of idle deposits, few borrowers), rates stay low to attract borrowers. When utilization is high (strong demand for borrowing), rates increase to attract more depositors and discourage excess borrowing.

This means rates can change rapidly. A rate that looks attractive today can shift meaningfully within hours if market conditions change. Variable rates are the norm on most platforms, though some offer fixed-rate products for borrowers who want predictability.

Practical considerations

Before borrowing on-chain, understand the specific LTV ratios, liquidation thresholds, and interest rate models for the platform and asset pair you're using. Set price alerts at levels well above your liquidation price so you have time to add collateral or repay part of the loan. And size your borrowing conservatively, because the worst time to get liquidated is during the exact market conditions that make it hardest to respond.