How Does the Use of Collateral Affect the Cost of Debt in DeFi?

The use of collateral significantly reduces the cost of debt in DeFi because the lender's risk is mitigated by the ability to liquidate the collateral if the borrower defaults. Over-collateralization, where the collateral value exceeds the loan amount, is common and further lowers the interest rate.

The cost of debt is therefore a function of the collateralization ratio, the volatility of the collateral, and the liquidation penalty.