Aave 101: Complete Beginner's Guide

What is Aave?

Aave is a decentralized, non-custodial liquidity protocol that enables users to supply and borrow cryptocurrencies. The name "Aave" comes from the Finnish word for "ghost," reflecting the protocol's transparent and open nature. Since its launch in 2020, Aave has become one of the largest and most trusted DeFi lending protocols in the cryptocurrency ecosystem.

Unlike traditional banks, Aave operates entirely on blockchain technology through smart contracts. This means Aave doesn't hold your funds—you maintain full custody of your assets while interacting with the Aave protocol. The Aave smart contracts automatically manage lending pools, interest rates, and collateralization, eliminating the need for intermediaries.

Key Features of Aave

Aave vs Traditional Banking

How Aave Works

Understanding how Aave works is essential for using the protocol effectively. Aave operates through a system of liquidity pools where suppliers deposit assets and borrowers take loans. Let's break down the Aave mechanics step by step.

The Aave Liquidity Pool Model

At its core, Aave uses a pooled liquidity model. When you supply assets to Aave, your funds enter a shared liquidity pool. Borrowers draw from this pool when taking loans. The Aave protocol uses algorithms to automatically set interest rates based on supply and demand—when more people borrow from Aave, rates increase; when more people supply to Aave, rates decrease.

Supplying Assets on Aave

When you supply (deposit) assets to Aave, several things happen:

1. Your assets enter the Aave pool: Your cryptocurrency joins the shared liquidity available for borrowers on Aave.
2. You receive aTokens: Aave gives you aTokens representing your deposit. For example, if you supply ETH to Aave, you receive aETH.
3. Interest accrues automatically: Your Aave aToken balance grows continuously as interest accumulates.
4. You can withdraw anytime: Redeem your aTokens for the original asset plus earned interest on Aave (subject to liquidity).

Borrowing on Aave

Aave allows you to borrow assets against your deposited collateral. Here's how borrowing works on Aave:

1. Supply collateral first: You must have assets supplied to Aave before borrowing.
2. Enable as collateral: Mark your supplied assets as collateral on Aave.
3. Borrow within your limit: Aave calculates how much you can borrow based on your collateral value and the asset's Loan-to-Value (LTV) ratio.
4. Pay interest over time: Your Aave debt increases as interest accrues.
5. Repay when ready: Return the borrowed amount plus interest to Aave to free up your collateral.

Over-Collateralization on Aave

A critical concept in Aave is over-collateralization. Unlike traditional loans where you might borrow $100,000 to buy a house, Aave requires you to deposit more value than you borrow. For example, if an asset on Aave has an 80% LTV, you can borrow up to $80 worth of assets for every $100 of collateral supplied to Aave.

This over-collateralization protects Aave suppliers. If a borrower's collateral value drops too low, Aave automatically liquidates a portion of their collateral to repay the debt and keep the protocol solvent.

Key Aave Concepts

To use Aave effectively, you need to understand these essential Aave concepts. Mastering these terms will help you navigate the Aave protocol with confidence.

Loan-to-Value (LTV) Ratio

The Loan-to-Value (LTV) ratio on Aave determines the maximum amount you can borrow against your collateral. Each asset on Aave has a specific LTV ratio set by Aave governance. For example:

• If ETH has an 80% LTV on Aave, you can borrow up to $80 for every $100 of ETH collateral
• Stablecoins on Aave typically have higher LTVs (75-80%)
• Volatile assets on Aave have lower LTVs (50-70%)

Liquidation Threshold

The Liquidation Threshold on Aave is the point at which your position becomes eligible for liquidation. It's always higher than the LTV. For example, an asset might have an 80% LTV but an 85% liquidation threshold on Aave. This buffer gives you time to add collateral or repay debt before Aave liquidation occurs.

Health Factor

The Health Factor is the most important metric to monitor on Aave. It represents the safety of your loan position on the Aave protocol:

• Health Factor > 1: Your Aave position is safe
• Health Factor = 1: You're at the liquidation threshold on Aave
• Health Factor < 1: Your Aave position will be liquidated

The Aave Health Factor formula: Health Factor = (Collateral × Liquidation Threshold) / Total Debt

aTokens

aTokens are Aave's interest-bearing tokens. When you supply assets to Aave, you receive corresponding aTokens (like aETH, aUSDC, or aDAI). Aave aTokens have unique properties:

• Rebasing: Your Aave aToken balance automatically increases as interest accrues
• 1:1 Pegged: Aave aTokens are always redeemable 1:1 for the underlying asset (plus interest)
• Transferable: You can send Aave aTokens to other wallets while still earning interest
• DeFi Compatible: Aave aTokens can be used in other DeFi protocols

Liquidation on Aave

Liquidation on Aave is the process of selling a borrower's collateral to repay their debt when their Health Factor falls below 1. Key aspects of Aave liquidation:

• Aave liquidators (other users) can repay up to 50% of your debt
• Liquidators receive your collateral at a discount (Aave liquidation bonus)
• After Aave liquidation, your Health Factor improves but you lose collateral
• Aave liquidation penalties typically range from 5-10% depending on the asset

Step-by-Step Aave Guide

Now that you understand Aave concepts, let's walk through the practical steps of using Aave for supplying, borrowing, and repaying.

How to Supply Assets on Aave

1. Connect to Aave:

   Go to app.aave.com and connect your Web3 wallet (MetaMask, WalletConnect, etc.) to the Aave interface.

2. Choose Network on Aave:

   Select the blockchain network where you want to use Aave (Ethereum, Polygon, Arbitrum, etc.).

3. Find Your Asset:

   In the Aave "Supply" section, locate the asset you want to deposit.

4. Enter Amount:

   Specify how much you want to supply to Aave.

5. Approve Transaction:

   First-time suppliers need to approve Aave to access their tokens. This is a one-time gas cost per asset on Aave.

6. Confirm Supply:

   Confirm the Aave supply transaction in your wallet. You'll receive aTokens representing your deposit.

How to Borrow on Aave

1. Ensure Collateral is Supplied:

   You must have assets supplied to Aave before borrowing. Check your Aave dashboard.

2. Enable Collateral:

   Toggle the "Use as Collateral" switch for your supplied assets on Aave.

3. Navigate to Borrow:

   Go to the "Borrow" section on Aave and choose the asset you want to borrow.

4. Select Amount and Rate:

   Enter your desired borrow amount on Aave. Choose between variable or stable interest rates (where available).

5. Review Health Factor:

   Aave shows your projected Health Factor. Ensure it stays well above 1.

6. Confirm Borrow:

   Approve the Aave borrow transaction. The borrowed funds appear in your wallet immediately.

How to Repay Loans on Aave

1. Go to Your Aave Dashboard:

   View your borrowed positions on the Aave app.

2. Select Repay:

   Click "Repay" next to the asset you borrowed on Aave.

3. Choose Amount:

   Enter the amount to repay. You can do partial repayments on Aave or repay in full.

4. Approve and Confirm:

   Approve Aave access to the token (if first time) and confirm the repayment transaction.

5. Check Your Health Factor:

   After Aave repayment, your Health Factor increases and you can withdraw more collateral.

Understanding Aave Interest Rates

Aave offers two types of interest rates for borrowers. Understanding these Aave rate options helps you make informed decisions about your loans.

Variable Interest Rates on Aave

Variable rates are the default on Aave. They fluctuate based on supply and demand in the Aave liquidity pools:

• Dynamic pricing: Aave rates change every block based on pool utilization
• Lower in normal conditions: Variable rates on Aave are typically lower than stable rates
• Can spike: During high demand, Aave variable rates can increase significantly
• Best for: Short-term Aave loans or when you can repay quickly

Stable Interest Rates on Aave

Stable rates on Aave provide more predictable borrowing costs:

• Semi-fixed: Aave stable rates remain constant unless market conditions change dramatically
• Higher premium: Stable rates on Aave are typically higher than variable rates
• Can be rebalanced: Aave may adjust stable rates if market conditions warrant
• Best for: Long-term Aave loans where rate predictability matters

How Aave Supply APY Works

Your earnings as an Aave supplier depend on:

• Utilization rate: Higher borrowing activity = higher Aave supply APY
• Interest from borrowers: Aave suppliers earn a share of interest paid by borrowers
• Reserve factor: A small percentage goes to the Aave DAO treasury

Risk Management on Aave

Proper risk management is crucial when using Aave. Understanding and mitigating risks will help you avoid Aave liquidation and protect your capital.

Monitoring Your Aave Health Factor

Your Aave Health Factor is the primary indicator of position safety. Here's how to manage it effectively:

• Check regularly: Monitor your Aave Health Factor at least daily during volatile markets
• Set alerts: Use DeFi monitoring tools to get notifications when your Aave Health Factor drops
• Maintain buffer: Keep your Aave Health Factor above 2.0 for safety
• Understand triggers: Know what price movements would bring your Aave position to liquidation

Avoiding Aave Liquidation

Prevent Aave liquidation with these strategies:

1. Conservative Borrowing:

   Don't borrow the maximum allowed on Aave. Leave a significant buffer.

2. Diversify Collateral:

   Use multiple assets as Aave collateral to reduce single-asset risk.

3. Keep Reserve Funds:

   Maintain funds outside Aave to add collateral if needed quickly.

4. Use Stablecoin Collateral:

   Stablecoins on Aave don't fluctuate, providing stable Health Factors.

5. Borrow Stablecoins:

   Borrowing stablecoins on Aave means your debt doesn't increase with market movements.

Understanding Aave Risks

Getting Started with Aave

Ready to start using Aave? Follow this guide to set up everything you need for your first Aave transaction.

Prerequisites for Using Aave

• Web3 Wallet: Install MetaMask, Rabby, or another compatible wallet to use Aave
• Cryptocurrency: Have some crypto to supply to Aave
• Gas Fees: Keep native tokens (ETH, MATIC, etc.) for Aave transaction fees
• Understanding: Read this Aave 101 guide thoroughly before proceeding

Connecting Your Wallet to Aave

1. Visit the official Aave app at app.aave.com
2. Click "Connect Wallet" on the Aave interface
3. Choose your wallet type for Aave access
4. Approve the connection request in your wallet
5. Verify you're connected by checking your address on Aave

Choosing an Aave Network

Aave operates on multiple blockchain networks. Consider these factors when choosing where to use Aave:

Your First Aave Supply

For your first Aave transaction, we recommend:

1. Start with a small amount you're comfortable learning with on Aave
2. Choose a stablecoin like USDC or DAI for your first Aave supply
3. Don't borrow on your first Aave interaction—just supply and observe
4. Watch how your Aave aToken balance grows over time
5. Practice withdrawing from Aave to understand the full cycle

Next Steps After Aave 101

Congratulations on completing Aave 101! You now understand the fundamentals of the Aave protocol. Continue your Aave learning journey with these resources: