Collateral and collateralization is when a borrower pledges an asset as a means for the lender to recoup their capital in the instance that the borrower defaults on the loan.
Defaulting on a loan or any sort of debt obligation is when the borrower fails to pay back the loan according to the original agreement.
By taking control of the collateral, the lender has an insurance that they can recoup the value of what was lent.
Let’s take an example. Imagine that you are about to purchase a property, however you don’t have the money to buy it outright. So, you take a mortgage to pay for it, wherein you are needed to collateralize with the underlying property.
When it comes to DeFi, open lending protocols use collateralized loans to fuel their ecosystem.
Most DeFi lending apps require their borrowers to collateralize their loans as a self-incentive to eventually pay back their loans in time.
In stablecoin protocols like MakerDAO, the borrowers are needed to overcollateralize their loan to account for crypto’s volatility.
Aave (previously known as EthLend) and it’s many copies and clones are clear examples of the benefits of DeFi. Users can use crypto as collateral and take out loans.
Unlike in TradFi, in DeFi no painful chats with young people in expensive suits are needed if you want to borrow funds: if you have the right and right amount of collateral, you will get the loan. No questions asked, doesn’t matter what you need the funds for, it’s all based on Smart Contracts.
- The value of your collateral determines the max size of your loan
- You can pay off your loan any moment you want, without any fines
- Interest is normally dynamic and based on supply and demand
- The max amount you can loan is dependent on the volatility of the collateral
- Once you paid off your loan you can withdraw your collateral
- If you don’t pay off your loan or your collateral falls below a set % of your loan, then your collateral might be sold (liquidation), to pay off your loan.