Crypto lending and borrowing: how it works and what can go wrong

Crypto lending lets you earn interest by supplying assets, and crypto borrowing lets you get cash or stablecoins without selling what you hold. Both run on collateral, and both can go badly wrong if the lender fails or prices drop fast.

How crypto lending works

A crypto loan has two sides. Lenders supply assets, often stablecoins, and earn interest. Borrowers pledge collateral, such as bitcoin or ether, and receive a loan against it.

Unlike a credit card or mortgage, there is usually no credit check. The lender protects itself by holding more collateral than the loan is worth and selling it if the loan becomes too risky. That single idea, overcollateralization, sits at the center of almost every crypto loan.

Lending happens in two very different settings: centralized companies (CeFi) and on-chain protocols (DeFi).

CeFi lending and the 2022 failures

In centralized finance, a company takes custody of your crypto. If you deposit to earn interest, the company lends or invests your assets and pays you part of the return. If you borrow, it holds your collateral in its own accounts.

That model depends on the company managing risk well and telling the truth about it. In 2022, several large US-facing lenders showed what happens when it does not.

• Voyager Digital filed for Chapter 11 bankruptcy on July 5, 2022, after a major borrower, the hedge fund Three Arrows Capital, failed to repay a large loan.
• Celsius Network froze withdrawals in June 2022 and filed for bankruptcy on July 13, 2022. A court-appointed examiner later found it had not properly segregated customer assets and had lost money on risky investments. Founder Alex Mashinsky pleaded guilty to fraud and was sentenced to 12 years in prison in May 2025.
• BlockFi filed for bankruptcy on November 28, 2022, shortly after the collapse of FTX, to which it had significant exposure. Earlier that year it had settled SEC and state charges over its interest accounts.
• Genesis, the lending arm behind the Gemini Earn program, halted withdrawals on November 16, 2022 and filed for bankruptcy on January 19, 2023.

Customers in these cases waited months or years for partial or full recoveries through bankruptcy courts. A key lesson: when a lender holds your assets, you may be treated as an unsecured creditor if it fails.

DeFi lending: Aave, Morpho and Compound

In decentralized finance, lending runs through smart contracts. You connect a self-custody wallet, deposit assets into a protocol, and the code tracks your balance, interest and collateral. Nobody approves your loan; the rules are the same for everyone and are visible on-chain.

• Aave runs large shared pools. Depositors earn interest from borrowers, and each collateral asset has risk settings chosen by Aave governance.
• Morpho uses isolated markets. Each market pairs one collateral asset with one loan asset, one price oracle and one liquidation threshold, and its parameters cannot be changed after launch. Separate vaults, run by curators, spread lenders' deposits across chosen markets.
• Compound is one of the earliest DeFi lending protocols and helped popularize the pooled model and algorithmic interest rates.

DeFi removes the risk of a company secretly misusing your funds, but it adds others: code bugs, faulty price feeds, governance changes and the absence of anyone to call if something goes wrong.

The lending side: earning interest

When you supply assets to a DeFi protocol, you usually receive a receipt token or an internal balance that grows as borrowers pay interest. You can normally withdraw at any time, with one important catch: you can only take out funds that are not currently lent.

If nearly everything in a market is borrowed, withdrawals can be delayed until borrowers repay or new lenders arrive. Protocols push rates sharply higher in that situation to fix the shortage, but there is no guarantee of instant access.

Lenders also carry the risk of bad debt. If collateral crashes so fast that liquidations cannot cover a loan, the shortfall can land on the lenders in that market. Isolated designs like Morpho's limit that damage to one market; shared pools spread it more widely, though they may also hold reserves to absorb losses.

In CeFi, the same risks exist but are hidden inside the company's balance sheet, which is why you depend so heavily on its disclosures and honesty.

LTV, health factor and liquidation

Loan-to-value (LTV)

Loan-to-value is your loan divided by your collateral's value. Borrow $4,000 against $10,000 of bitcoin and your LTV is 40%. Each platform sets a maximum LTV for opening a loan and a higher liquidation point. On Coinbase's crypto-backed loans, for example, LTV must stay under 86% to avoid automatic liquidation.

Health factor

Aave and similar protocols express the same idea as a health factor. Aave calculates it as total collateral value multiplied by the weighted liquidation threshold, divided by total borrowed value. Above 1, the position is safe from liquidation; below 1, it can be liquidated.

Aave's own example: supply $10,000 of ETH with an 80% liquidation threshold, borrow $6,000, and your health factor is about 1.33. A drop of roughly a quarter in ETH's price would push it to 1.

Liquidation

When a position crosses the line, outside participants called liquidators repay part of your debt and receive your collateral at a discount. On Aave, up to half the debt can be liquidated in one step in many cases, and all of it once the health factor falls to 0.95 or below. You keep the loan proceeds, but the sold collateral is gone, along with the liquidation bonus paid to the liquidator.

Fast crashes are the main danger. Prices can fall through your liquidation point in minutes, faster than you can add collateral.

How interest rates are set

Most DeFi lending markets set rates by formula rather than by a loan officer. The key input is utilization: the share of deposited funds that is currently borrowed.

• When utilization is low, plenty of funds are idle, so borrowing is cheap and lenders earn little.
• As utilization rises, rates climb gradually.
• Past a set level, often called the "kink," rates rise steeply. That pushes borrowers to repay and draws in new lenders, so depositors can still withdraw.

The practical result is that DeFi rates are variable and can change hour to hour. A loan that is cheap today can become expensive during a market rush. Some services now offer fixed-rate loans for set terms, which trade flexibility for predictability.

Crypto-backed loans from US platforms

As of October 2026, the most visible US offering is Coinbase's crypto-backed loans, which run on Morpho on the Base network. Key details, according to Coinbase:

• You borrow USDC against crypto held in your Coinbase account. Bitcoin is converted to Coinbase Wrapped BTC (cbBTC) and moved into a Morpho smart contract as collateral.
• Eligible collateral includes BTC, ETH, SOL, XRP, DOGE, ADA, LTC and several others, with limits that vary by asset; Coinbase lists up to $5 million against bitcoin.
• Variable-rate loans have no fixed term or monthly payments; fixed-rate loans have a maturity date and must be repaid in full by then.
• It is available to verified US customers except in New York, with limited access in the UK.

Other companies also offer bitcoin-backed loans. Before using any lender, check whether it holds the right state licenses, whether it rehypothecates (re-lends) your collateral, and what happens to your collateral if it fails.

Before you borrow: a short checklist

1. Know your liquidation price and how far the market would have to fall to reach it.
2. Borrow well below the maximum. A low starting LTV buys you time when prices drop.
3. Plan how you would add collateral or repay, and keep those funds ready.
4. Set alerts for your LTV or health factor rather than checking by hand.
5. Read the fees: processing fees, platform fees and liquidation penalties all add to the real cost.
6. Understand custody: know whether your collateral sits with a company, in a smart contract, or in a wrapped form.

The main risks

• Liquidation risk: sharp price drops can sell your collateral at the worst moment.
• Counterparty risk (CeFi): the company may lose, lend out or misuse your assets, as the 2022 failures showed.
• Smart-contract risk (DeFi): bugs or exploits can drain a protocol, even an audited one.
• Oracle risk: a wrong or manipulated price feed can trigger liquidations that should not happen.
• Stablecoin risk: if you lend or borrow a stablecoin that loses its peg, your position changes value unexpectedly.
• Rate risk: variable rates can rise quickly when demand spikes.
• Wrapped-asset risk: using wrapped tokens such as cbBTC adds reliance on the custodian that backs them.

Our crypto risk management guide covers position sizing and other ways to limit damage.

Tax basics

The IRS treats cryptocurrency as property, so selling or exchanging it can create a taxable gain or loss. Crypto lending raises a few specific points, though the IRS has not issued detailed guidance on every lending arrangement:

• Interest you earn from lending is generally taxable income.
• Borrowing is generally not income, because you owe the money back. Coinbase says it does not treat its borrow transactions as taxable events.
• Liquidations sell your collateral, which can trigger capital gains or losses.
• Wrapping or swapping collateral before depositing it may or may not be a taxable exchange; treatment is unsettled, so keep careful records.

See our crypto tax guide for more, and speak with a tax professional about your own situation.

Updated October 4, 2026 by The Crypto Guide editorial team. Educational content, not financial, legal or tax advice. Spot an error? Request a correction.