What is Aave? Complete Beginner's Guide
Everything you need to know about the leading DeFi lending protocol - how it works, how to use it safely, and the key concepts you must understand before depositing.
In This Guide
What is Aave?
Aave is a decentralized lending protocol that lets you deposit cryptocurrency to earn interest, or use your crypto as collateral to borrow other assets. Think of it like a crypto bank, but instead of a company managing your money, everything is handled automatically by smart contracts on the blockchain.
Launched in 2020 as an evolution of ETHLend, Aave has become one of the largest DeFi protocols with billions of dollars in total value locked (TVL). The name "Aave" means "ghost" in Finnish - a nod to its creator Stani Kulechov's heritage and the protocol's transparent, ethereal nature.
Aave at a Glance
- Type: Decentralized lending/borrowing protocol
- Launched: 2020 (Aave V1), current version is Aave V3
- Blockchains: Ethereum, Arbitrum, Optimism, Polygon, Base, Avalanche, and more
- Governance: AAVE token holders vote on protocol changes
- Key Innovation: Flash loans (uncollateralized single-transaction loans)
Why Use Aave?
People use Aave for several reasons:
- Earn yield on crypto you're holding anyway (3-10%+ APY on stablecoins)
- Access liquidity without selling your crypto (avoid triggering taxes)
- Leverage your position by borrowing to buy more of an asset
- Short assets by borrowing and selling them
- Arbitrage using flash loans for instant, uncollateralized borrowing
How Aave Works
Aave operates through liquidity pools - smart contracts that hold deposited assets. When you supply crypto, it goes into a pool that borrowers can access. The protocol automatically adjusts interest rates based on supply and demand.
The Two Sides of Aave
Suppliers (Lenders)
- Deposit crypto into pools
- Receive aTokens (interest-bearing)
- Earn yield from borrower interest
- Can withdraw anytime (if liquidity available)
Borrowers
- Deposit collateral first
- Borrow up to a % of collateral value
- Pay interest on borrowed amount
- Must maintain healthy collateral ratio
Interest Rate Dynamics
Aave uses an algorithmic interest rate model based on utilization - what percentage of deposited assets are currently borrowed:
- Low utilization (0-80%): Rates increase gradually
- High utilization (80%+): Rates spike sharply to attract deposits
- This balances the system: High demand → high rates → more deposits → lower utilization → lower rates
Key insight: Suppliers earn less than borrowers pay. The difference (the "spread") goes to the protocol treasury and safety reserves.
Supplying Assets (Earning Yield)
When you supply (deposit) assets to Aave, you receive aTokens in return. These are interest-bearing tokens that represent your deposit plus accumulated interest.
How aTokens Work
Your USDC goes into the Aave pool. You receive 1,000 aUSDC.
At 5% APY, after one year you'd have ~1,050 aUSDC (no claiming required)
Burn your aUSDC to receive USDC (1:1 ratio). Your 1,050 aUSDC = 1,050 USDC.
What Affects Supply APY?
- Utilization rate: Higher borrowing demand = higher yields
- Asset type: Stablecoins typically have higher, more stable yields
- Market conditions: Bull markets often see higher borrow demand
- Network: Layer 2s may have different rates than Ethereum mainnet
Supply as Collateral
By default, supplied assets can be used as collateral for borrowing. You can toggle this off if you only want to earn yield without borrowing risk. Some assets may not be eligible as collateral due to risk parameters.
Borrowing Assets
To borrow on Aave, you must first supply collateral. Your borrowing power depends on your collateral value and the asset's Loan-to-Value (LTV) ratio.
Borrowing Example
You deposit: 10 ETH @ $3,500 = $35,000
ETH Max LTV: 80%
Your borrowing power: $35,000 × 80% = $28,000
You borrow: 15,000 USDC
Remaining power: $28,000 - $15,000 = $13,000
Key Borrowing Parameters
- LTV (Loan-to-Value): Maximum you can borrow as a % of collateral (e.g., 80%)
- Liquidation Threshold: The LTV at which you get liquidated (e.g., 83%)
- Liquidation Penalty: Extra collateral lost if liquidated (e.g., 5%)
- Variable Rate: Interest rate that fluctuates based on utilization
Why Borrow Instead of Sell?
Borrowing lets you access liquidity without giving up your crypto position:
If You Sell ETH:
- Trigger taxable event (capital gains)
- Miss future price appreciation
- Must buy back at unknown future price
If You Borrow Against ETH:
- Keep your ETH exposure
- Benefit if ETH price rises
- Pay only interest (often 3-8% APR)
Health Factor & Liquidation
Health Factor is the most important number to watch when borrowing. It measures how safe your position is:
Health Factor Scale
How Health Factor is Calculated
Your Health Factor drops when:
- Your collateral price falls
- Your debt value rises (if you borrowed volatile assets)
- Interest accrues on your debt
What Happens During Liquidation?
When Health Factor drops below 1:
- Liquidators can repay up to 50% of your debt
- They receive your collateral at a discount (the liquidation bonus, typically 5-10%)
- You keep your borrowed assets but lose more collateral than the debt was worth
- Your Health Factor improves, hopefully above 1
Liquidation Example
You have $35,000 ETH collateral and $28,000 USDC debt. ETH drops 20%:
- Collateral now worth: $28,000
- Health Factor drops below 1
- Liquidator repays $14,000 of your debt
- Liquidator takes ~$15,400 of your ETH (10% bonus)
- You still have $14,000 USDC but only ~$12,600 ETH left
- Net loss: ~$2,800 (the liquidation penalty)
Pro tip: Use our Liquidation Calculator to find your exact liquidation price, and our Health Factor Calculator for quick safety checks.
Key Aave V3 Features
E-Mode (Efficiency Mode)
E-Mode allows higher LTV when borrowing assets that are correlated in price. Since stablecoins all track $1, borrowing one stablecoin against another is lower risk - so Aave allows up to 97% LTV in stablecoin E-Mode.
E-Mode Categories
- Stablecoins: USDC, DAI, USDT - up to 97% LTV
- ETH Correlated: ETH, wstETH, rETH - up to 93% LTV
Isolation Mode
New or risky assets may be listed in Isolation Mode - they can only be used as collateral in isolation, not mixed with other collateral. This limits the damage if the asset crashes.
GHO Stablecoin
GHO is Aave's native decentralized stablecoin. Instead of borrowing existing stablecoins from a pool, you "mint" GHO directly against your collateral. Benefits:
- Often lower interest rates than borrowing USDC/DAI
- stkAAVE holders get discounted GHO rates
- Interest goes to Aave DAO treasury
Flash Loans
Aave pioneered flash loans - uncollateralized loans that must be borrowed and repaid within the same transaction. If the loan isn't repaid, the entire transaction reverts. Used for arbitrage, collateral swaps, and self-liquidation.
Multi-Chain Deployment
Aave V3 is deployed on multiple networks. Layer 2s like Arbitrum and Optimism offer the same functionality with much lower gas costs - a $50 transaction on Ethereum mainnet might cost $0.10 on Arbitrum.
Risks to Understand
Aave is battle-tested with billions in TVL and multiple audits, but all DeFi carries risk:
Smart Contract Risk
Bugs in smart contracts could lead to loss of funds. Aave has been extensively audited, but no code is 100% bug-free.
Liquidation Risk
Borrowing volatile collateral means price crashes can trigger liquidation. Always maintain a healthy buffer.
Oracle Risk
Aave relies on Chainlink oracles for prices. Oracle manipulation or failure could affect liquidations.
Stablecoin Risk
Stablecoins can depeg. Borrowing stables against stables is low risk unless the collateral stablecoin loses its peg.
Withdrawal Risk
If utilization hits 100%, you can't withdraw until someone repays or deposits more. This is temporary but can be inconvenient.
Golden rule: Never deposit more than you can afford to lose. Start small, learn the mechanics, then scale up.
Getting Started Safely
Step-by-Step Guide
Use our Aave Simulator to understand the mechanics without risking real money.
Get MetaMask or another Web3 wallet. Back up your seed phrase securely.
For lower fees, start on Arbitrum or Optimism. Bridge assets from Ethereum if needed.
Deposit stablecoins to earn yield. No liquidation risk if you're not borrowing.
If you borrow, keep Health Factor above 1.5-2.0 for safety margin.
Best Practices
- Monitor your position: Check Health Factor regularly, especially during volatile markets
- Set price alerts: Know what price would trigger liquidation
- Keep dry powder: Have assets ready to add collateral if needed
- Understand the assets: Know the LTV, liquidation threshold, and penalty for each asset you use
- Use E-Mode wisely: Higher LTV means less margin for error
Frequently Asked Questions
What is Aave?
Aave is a decentralized lending protocol where you can deposit crypto to earn interest or use your crypto as collateral to borrow other assets. It runs on Ethereum and other blockchains, operating through smart contracts without intermediaries.
Is Aave safe?
Aave is one of the most battle-tested DeFi protocols with billions in TVL and multiple security audits. However, all DeFi carries risk including smart contract bugs and market volatility. Never deposit more than you can afford to lose.
How do I make money on Aave?
You earn money on Aave by depositing crypto into lending pools. Interest rates vary by asset - stablecoins typically earn 3-10% APY while volatile assets earn less. Rates change based on supply and demand.
What happens if I get liquidated on Aave?
When your Health Factor drops below 1, liquidators can repay up to 50% of your debt and claim your collateral at a 5-10% discount. You keep your borrowed assets but lose collateral worth more than your debt plus the penalty.
What is E-Mode on Aave?
E-Mode (Efficiency Mode) allows higher borrowing power when using correlated assets. For example, in stablecoin E-Mode, you can borrow USDC at 97% LTV using DAI as collateral since both maintain ~$1 value.
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Financial Disclaimer: The information provided on this website is for educational and informational purposes only and should not be construed as financial, investment, or legal advice. Cryptocurrency and DeFi investments involve substantial risk, including the possible loss of principal. Past performance does not guarantee future results. Always conduct your own research and consult with a qualified financial advisor before making any investment decisions.
Educational Purpose: This content is designed to help you understand DeFi concepts and is not a recommendation to buy, sell, or hold any cryptocurrency or use any particular protocol. The examples and calculations shown are for illustrative purposes only.
Risk Warning: DeFi protocols carry inherent risks including but not limited to: smart contract vulnerabilities, liquidation risk, impermanent loss, protocol insolvency, and regulatory changes. Never invest more than you can afford to lose.