DeFi Lending Revolution: Overcollateralization Replaces Traditional Credit Scoring

Onchain lending has revolutionized the way people borrow money by eliminating traditional credit scoring methods and replacing them with overcollateralization. This means that borrowers deposit an asset worth more than what they want to borrow, and a smart contract holds it as security.

This approach works because the protocol lends based on the value of the collateral rather than the borrower's history or identity. The deposited asset stays within the smart contract until the loan is repaid, and if the borrower defaults, the contract sells the collateral automatically.

The health factor is a key component of this system. It's a live score calculated from the ratio of the weighted collateral value to the outstanding debt. If the health factor falls below 1.0, liquidation bots are triggered, and part of the collateral is sold to repay the loan.

Aave, Compound, and other protocols have extended this model across multiple chains, with over $40 billion in total value locked as of mid-2026. The interest rates in DeFi lending are determined algorithmically based on the utilization rate, which is the percentage of deposited liquidity that's currently being borrowed.