By Alan

You can earn yield by lending and borrowing crypto assets.

DeFi lending protocols like Aave or Compound provide higher yields than traditional banks by using smart contracts instead of middlemen. In this guide, we’ll walk through:

1. A simple analogy
2. How do lending protocols work?
3. How to deposit assets?
4. How to borrow assets?
5. What are the risks?

What follows is not investment advice.

A simple analogy

Suppose that you’re going on vacation and won’t be using your car for a few months. Normally, your car would sit in your garage collecting dust. Instead, you decide to rent it out to a friend. You (the lender) can make money, and your friend (the borrower) can use your car to get stuff done.

Keep this analogy in mind as we explore the next topic.

How do lending protocols work?

In the example below, we’ll lend (deposit) some DAI into Aave (a popular lending protocol) using Polygon. Polygon is an Ethereum L2 scaling solution that offers faster and cheaper transactions. To try this example yourself, you first need to have:

1. A crypto wallet (see How to set up a wallet?)
2. Some DAI on the Polygon chain(see How to use L2 chains? and How to swap tokens?)

1. Visit Aave and navigate to the “Markets” tab

Using the screen above as an example:

1. If you deposit DAI, you’ll earn 1.16% APY in extra DAI
2. If you borrow DAI, you’ll pay 2.57% APY 

Deposit and borrow APYs are based on the supply and demand of the market.

2. Deposit some DAI

Suppose you want to deposit 10 DAI (~$10 USD). Select Deposit DAI and tap Approve:

Let’s define a few terms from the dashboard above:

1. Collateral usage: If this is set to Yes, then your deposited DAI can be used as collateral for whatever assets you borrow.
2. Maximum LTV (Loan-to-Value): The borrowing power for this collateral. In our example, we deposited 10 DAI, so we’ll be able to borrow up to 7.5 DAI worth of assets (75%). ‍
3. Liquidation threshold: The level in which the loan will be seen as undercollateralized. For DAI, it is 80%. If market conditions change so that your borrowed assets are worth more than 80% of your collateral value, some of your collateral will be sold to pay off part of the loan.
   

How to borrow assets?

Let’s use our DAI deposit to borrow some MATIC (Polygon’s native token):

1. Select how much to borrow: We can borrow up to the maximum, 75%, of our collateral. 
2. Monitor the health factor: The health factor is a formula that monitors the value of your borrowed assets compared to your collateral value. The higher the health factor, the less likely you are to be liquidated.

Hit borrow and confirm the transaction and you should see the MATIC in your wallet soon!

‍

What are the risks?

Crypto assets are volatile. If your collateral loses value, then your borrow balance may exceed the limit, which increases your risk of getting liquidated (losing some or all of your collateral). 

To avoid liquidation: 

1. Be conservative: Avoid borrowing up to your limit.
2. Use stable collateral: Use stablecoins as collateral since they generally don’t fluctuate in price.
3. Monitor the health of your loans: You can add more collateral if you get close to your health factor limit. 

Borrowing is not for the passive or beginner investor. Leverage can increase your returns, but comes with risk and requires monitoring. 

Up next: How to Provide Liquidity?