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It Pays to Borrow on Aave

By RockHoward | Rock's DeFi Playbook | 7 May 2021

Today we start looking at the Aave Lending Dapp and we will go over the first real DeFi play from my playbook. This is a great time to try Aave as special promotions grant extra rewards to dapp users making it easy to goose your returns. You can even make money by borrowing. What? Certainly there is a trick? Not really. After an overview of the dapp I will walk you through the process.

Getting Started with Aave V2 on the MATIC Network

You bring up Aave Lending Platform by visiting and connecting your wallet on the MATIC Network. (Make sure that you are on MATIC/Polygon because if your are on Ethereum then the transaction fees may eat you alive. On MATIC you can basically ignore transaction fees and that is what we do in this article.) The Aave app is quite beautiful but a bit intimidating at first. Don't worry. It is easy to use once you understand the basics about depositing and borrowing tokens. Currently all of the rewards are paid out in WMATIC (a wrapped version of the MATIC token) and you can claim them whenever you choose. We will get started by visit the first four menu pages.

The MARKETS Page shows the 7 coins that you can deposit into Aave V2. Three of them are stable coins (USDC, DAI and USDT). The others are wrapped BTC (WBTC), wrapped Ethereum (WETH), MATIC and AAVE. This page shows the interest that you earn by depositing and borrowing each of these tokens. These are variable rates that depend on factors such as available liquidity for each coin. Both deposited and borrowed tokens compound automatically in basically real time and so the interest rates are shown as APYs. The rewards accrue until you claim them. Claiming moves them into your wallet. Thus there is no automatic compounding of the rewards and therefore the rewards are shown as APRs.

Usually the lowest liquidity token is USDT (Tether) and so it usually has the highest rates of interest for depositors and borrowers alike. Before you pile into USDT however, realize that it is unique in the MATIC version of Aave as it is the only coin that cannot be used to collateralize loans. The other oddball coin is AAVE. You can't earn interest on it nor borrow it. Instead you simply earn rewards for depositing it in what amounts to an unusual form of staking. (True staking of AAVE is only available on the Ethereum version of the Aave dapp.)

Your First Deposit

Let's visit the DEPOSIT page next. This one is quite clear. On the left you see each of the 7 supported tokens along with how much of them that you currently hold in your connected wallet. On the right are the tokens that you have already deposited. Simple select the token that you want to deposit and you get switched to a view where you can type in the amount that you want to deposit. If you wish you can go ahead and do so (taking care never to deposit all of your MATIC) and then hit "Continue". Now you see the Deposit Overview including a button labelled "Deposit" which begins the transactions to deposit your tokens. (You are also shown a "health factor" if you have a loan in process, but we will explain that later.)

There are no fees besides the transaction costs for depositing, withdrawing and claiming your rewards and so Aave is a splendid place to keep your spare tokens when they aren't being used for some other purpose. The interest earned is generally small, but the compounding is continual and pays in the same token as the underlying deposit. This means that your exposure to token price fluctuations is not materially changed by depositing into Aave.

The Dashboard

Now switch to the MY DASHBOARD page. This is your main summary view that shows your deposits and borrows. Notice that you can hover your mouse over any of the balances for deposits or borrowings and a higher precision version of the number appears. So slick! It even updates in near real time so that you can see the compounding in action. This page is also where you may start a withdrawal of your deposits. Similarly once you have borrowed tokens, then you may also use this page to perform a partial or full repayment.

Besides your deposits notice the "Available reward" box in the upper right. This is where all of the rewards from your various deposits and borrowings accrue. When that number gets large enough for you to bother with then you can use the "Claim" button to begin the transaction what will deliver the reward to your wallet as WMATIC tokens. (If WMATIC doesn't yet appear in your wallet then look at my recent blog post about adding token types to metamask in order to make this happen.)

For the first 4 months of Aave on the Matic network the Polygon Foundation is contributing most of the rewards. The eye popping APRs and the ability to earn rewards for borrowing are attracting a lot of new liquidity to the Matic Network which, after all, was the point of the promotion. Why are the rewards in APR while the deposit and borrowing interest are in APY? Compounding! Your deposits and borrowings automatically compound over time. Your rewards just add up over time and you claim them directly into your wallet and thus there is no automatic compounding.

Now the Fun Begins by Borrowing!

If you only use Aave for savings then you are missing the point as other dapps can deliver higher returns on deposits. The ability to leverage your holdings in a variety of ways is what makes Aave special and is why it is known as a lending platform. We will discuss a very safe way to borrow in this article but there are many other possibilities some of which we will discuss in a future article. First though let's understand the basic rules.

Tokens vary in how much they can be used as collateral. USDC and WETH can be used up to 80%. Others are 50% to 70% except for Tether (USDT) which cannot be used as collateral at all. Fortunately you don't have to remember all of these details. Just open the BORROW page and the dapp will tell you how much that you can borrow as well the compounding interest rate, and the non-compounding rewards rate.

While you review the available borrowing options you will probably notice that some of them offer high enough reward rates that the interest rates for the loan are covered entirely! If you think this smells like free money, then you are right although it is not entirely risk free as all of these rates are variable and changing conditions can change the attractiveness of your particular deal.

Before jumping in and borrowing the max let's understand how Aave protects itself from bad loans. The bottom line is that loans that go bad trigger
liquidation of the associated collateral. In addition Aave imposes an additional penalty against the borrower. Accordingly you want to be careful not to get into this situation. Fortunately Aave has devised a way to make this very clear once you understand how it works. Every potential or open loan has a "health factor". This factor is higher for safer loans and lower for riskier situations. A medium risk health factor is 2 but the number can get much higher if your loan is small enough. Now this health factor can and does change as the relative value of your collateral and your loaned tokens changes. It can drop without a problem but if the health factor ever drops to 1, then the liquidation process is triggered.

Deciding what health factor to target depends on a lot of factors. One of them is the relative volatility of the collateral and the borrowed tokens. If, for example, your collateral is all USDC and the borrowed tokens are all USDC as well, then it is unlikely that the health factor will change very much over time unless the variable rate loan rate goes way up. In this situation you can take out a "riskier" loan around 1.5 or so and there is unlikely to be any problems. If no stable coins are involved either as collateral or as loaned tokens, then the health factor can change quite a lot just from changes in the markets. In this case it is wiser to at least start out with a health factor of 2 or more.

One last tip: keep an eye on the repayment amount. If you borrow 100 tokens then later if you repay 100 tokens then you will find that the loan has not been fully paid off as at least a fractional amount of a token has been added to your loan amount. If you screw this up it is not a problem from a financial standpoint but it is a pain to have to go back and perform another repayment to finish up the loan.

Rock's DeFi Play #1 -- Running a Simply Pump on Aave

For this play we deposit a healthy chunk of USDC into Aave. Using that as collateral we then borrow more USDC targeting a health factor around 1.5 to 1.6. After taking out this loan, we then deposit the borrowed token back into Aave. Viola. We are making interest and rewards on our inflated deposits as well as rewards for taking out the loan. The cost is the interest on the loan. When I tried this yesterday the income generated was 8 times the cost. Now the overall return on investment was not stupendous, but certainly much better than the rate generated on the original amount.

Caution: When you unwind this position be careful to start by withdrawing just the tokens that you need to repay the loan. If you lazily withdraw way more than that then you might put yourself in a situation where you get close to liquidation. There is no need to take that risk.

Am I recommending this play? No. I am not a financial advisor. I am just showing you something that is possible and potentially useful. You can vary the play in different ways by using different tokens for collateral or for your loan. You can also ponder reborrowing and redepositing but personally I have never pushed things to the next level like that.

In the near future we will look at other Aave based plays that offer a little more spice in terms of potential returns, but first I want to introduce a different dapp focused on maximizing returns on deposited stable coins named mStable that works great in the right situations.

Credit: Photo by David McBee from Pexels

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I am a software developer (among other things) that is focused on the Radix Network. I run a free discord for programmers who want to study Rust and/or Scrypto. I also run the Radix Programmer's Guild.

Rock's DeFi Playbook
Rock's DeFi Playbook

Learn the specific steps needed to perform the most common DeFi operations. Starting with Metamask and then moving on to a variety of dapps on the Polygon (aka Matic) Network, you will learn how to perform staking, providing liquidity, leveraged trading, yield farming and buying and selling options. You will need to do your own research on your best course of action as nothing in this blog is financial advice.

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