The over-collateralization model

Why you deposit more than you borrow

A bank lends you $20,000 for a car because they checked your credit and your job. They believe you will pay it back. DeFi lending protocols can't do that — they don't know who you are. So they solve the trust problem with collateral. Want to borrow? Deposit assets worth more than the loan first. That is over-collateralization, and it is the single design choice that makes permissionless lending work.

Each asset has a loan-to-value cap, called LTV. ETH might be set to 75% LTV, meaning you can borrow up to 75% of your deposited ETH's value. Deposit $500 of ETH, you can borrow up to $375. A less liquid asset might be capped at 50% — deposit $500, borrow $250. The riskier the collateral, the lower the cap. Some volatile or thin assets have an LTV of 0% — you can hold them but you can't borrow against them.

There is a second number that matters more in practice: the liquidation threshold. It is slightly higher than LTV. ETH might have LTV 75% and liquidation threshold 82%. The gap between them is your buffer. You can borrow up to 75%, but you only get liquidated when your debt exceeds 82% of your collateral. The protocol gives you a few percent of headroom on purpose, because prices can move fast.

Worked example. You deposit $500 of ETH (LTV 75%, liq threshold 82%). You borrow $300 of USDC. Health factor = ($500 × 0.82) / $300 = 1.37. Now ETH drops 30%. Your collateral is worth $350. Health factor = ($350 × 0.82) / $300 = 0.96. You're now under 1 — anyone in the world can pay off your debt and take your collateral. Welcome to liquidation.

The retail practical rule: never borrow at the maximum LTV. If the cap is 75%, borrow 30-40%. That gives you room to survive a normal market correction without getting wiped on a single bad day. The cheaper you make your loan look, the closer you get to being a feature of the next liquidation cascade — which is the topic of lesson 8.

Recap: DeFi lending requires more collateral than the loan. LTV is the borrow cap, liquidation threshold is the cliff. Health factor above 1 means you're safe. Borrow conservatively — well below the max — and you survive normal drops.