Learn · season 04 · episode 11
Aave: lending, borrowing and liquidation
Suppliers put tokens into a pool. Borrowers take tokens out and owe them back with interest. Collateral gives the protocol something to recover if a loan becomes undercollateralised.
A beginner lesson using Aave V3 mechanics. All numbers are fictional browser simulations. No wallet, live rates or real funds.
Where does borrowed money come from?
You will be able to explain who supplies a loan, what the borrower owes, and why a falling pledged asset can put that asset at risk.
First look · fictional balances
Follow the money before the formulas
Predict: if the pledged asset loses value, does the amount borrowed shrink too? Take one action at a time.
Supplier wallet
10,000 USDC
Lending pool
0 USDC
Borrower wallet
0 USDC
Each filled square represents 1,000 USDC. The three locations total 10,000 USDC.
- Pledged asset
- 0 WETH · worth $0.00
- Borrower’s repayment obligation
- 0 USDC before interest
The supplier has 10,000 USDC. The borrower has 2 WETH. No loan exists yet.
USDC is held at $1; WETH is wrapped ETH. Prices and risk settings are invented. This shows liquidation eligibility, not an executed sale. Interest and other users’ transactions are omitted.
Source: Aave V3 supply, borrow, repay and withdraw.
Income, loss and getting out: borrowers pay interest that supports supplier income. Suppliers can lose through bad debt, token problems or contract failures. A supplier also needs available pool liquidity to withdraw; a growing claim does not guarantee cash now. Borrowers must repay enough debt before removing collateral that supports it.
Explain it back
A borrower pledges a different asset, then that asset loses value overnight. The borrowed token stays at the same price. Why does the borrower still owe the loan, and what can happen to the pledged asset?
Compare your explanation
The loan is owed in the borrowed token. A fall in the pledged asset changes the protection behind the loan, not the token amount owed. If the position crosses the applicable risk boundary, liquidation can take collateral to repay debt. A lower price does not itself prove liquidation has executed.
Explore the balances, risk limits and interest-rate model
01 · follow the balances
The pool connects suppliers and borrowers
Aave is a lending protocol implemented in smart contracts. Each supported token has a reserve: supplied tokens are available for borrowing. A supplier earns interest through a supply claim; a borrower supplies eligible collateral and takes on debt.
Here, WETH means wrapped ETH. We hold USDC at $1. The supplier lends USDC; the borrower supplies WETH as collateral. These are two reserves, not a token swap. The borrower still has exposure to WETH’s price.
Follow the tokens
Supplier
Wallet: $10,000.00 USDC
Supply claim: $0.00 USDC
USDC reserve
Available: $0.00
Loan outstanding: $0.00
Borrower
Wallet: $0.00 USDC + 2 WETH
Debt: $0.00 USDC
1 / 5 · Before supplying
A supplier holds 10,000 USDC. A separate borrower holds 2 WETH. The USDC reserve is empty.
This short sequence omits elapsed time and interest. Real debt accrues interest in the borrowed token. Withdrawal also needs available liquidity and sufficient remaining collateral if debt is outstanding.
Source: Aave V3 liquidity pool: supply, withdraw, borrow and repay.
02 · two different limits
Borrowing capacity is not the liquidation boundary
Loan-to-value (LTV) limits new borrowing relative to collateral value. With $4,000 collateral and a fictional 70% LTV, the limit is $2,800. Liquidation threshold is a separate risk parameter: at 80%, the health-factor boundary is $3,200 of debt.
Health factor (HF) compares collateral adjusted by that threshold with total debt. For one collateral asset: HF = collateral value × liquidation threshold ÷ debt. With $4,000 collateral and $2,000 debt, HF is 1.6. A position becomes eligible for liquidation below 1.
Try reducing WETH to $1,000, then reduce the debt. A price fall reduces collateral value without reducing how many USDC are owed. Interest accrual also increases debt over time; the debt slider can represent that change. Nothing advances automatically.
Stress an existing loan
Illustrative · computed hereFixed collateral: 2 WETH. Fictional LTV: 70%; liquidation threshold: 80%. Debt is USDC at $1. These controls describe a possible existing position, not permission to open a loan above LTV.
- Collateral value · 2 × price
- $4,000.00
- Borrow limit · collateral × 70%
- $2,800.00
- Liquidation boundary · collateral × 80%
- $3,200.00 of debt
- Health factor · boundary / debt
- 1.600
Within the example borrowing limit. HF above 1 is not a guarantee against future liquidation.
Keeping this debt unchanged, HF reaches 1 at $1,250.00 per WETH. Below that price the position is eligible for liquidation.
Additional borrowing capacity from LTV alone: $800.00. Actual borrowing also depends on liquidity, caps and other market rules.
In a liquidation, a liquidator repays debt and receives collateral plus a liquidation bonus. This lesson marks eligibility only; it does not simulate execution or assume a fixed percentage is always liquidated. With multiple collateral assets, health factor uses their value-weighted liquidation thresholds.
Sources: Aave reserve parameters and health factor and liquidations.
03 · the price of borrowing
Variable rates respond to pool usage
Utilisation measures how much of a reserve is borrowed. Higher utilisation leaves fewer tokens available. A rate curve can increase borrowing cost more sharply above a target, encouraging repayment or more supply. This reserve-wide measure is separate from one borrower’s health factor.
When available liquidity gets scarce
Illustrative · computed hereA separate USDC reserve has 10,000 supplied. Move utilisation: the percentage currently borrowed. This toy curve has a 2% base borrow APR, rises to 6% at 80% utilisation, then rises more steeply to 66% at 100%.
- Borrowed from the reserve
- $5,000.00
- Available to withdraw or borrow
- $5,000.00
- Variable borrow APR
- 4.50%
- Estimated supply APR
- 2.02%
Supply APR ≈ borrow APR × utilisation × 90%. Only borrowed funds pay interest; this example allocates 10% of borrower interest to the protocol reserve factor. At 0% utilisation, supply interest is zero even though the quoted borrow rate is 2%.
APR is an annualised rate before compounding, not a promised annual return. This snapshot omits incentives, fees, losses and changing rates. Real parameters vary by asset, market and protocol version.
Sources: interest-rate strategy and reserve factor and variable borrowing rates.
What this model leaves out
Real markets have changing prices, interest, liquidity and governance settings. Asset caps, collateral modes, oracle behaviour and liquidation rules add constraints. Smart-contract failures, token depegs and bad debt can affect suppliers too. This model teaches the relationships; it does not estimate a return or choose a borrowing level for you.