If you borrow on a DeFi lending protocol such as Aave, one number decides whether your collateral gets sold: the health factor. Keep it above 1 and you are fine. Let it drop below 1 and liquidators can sell part of your collateral, with a penalty on top. This explains how it is calculated, with a worked example, and how to keep a position safe.
This is an educational explainer, not financial advice. Crypto trading is restricted for residents of Nepal by Nepal Rastra Bank.
Quick answer
Health factor = (collateral value x liquidation threshold) / borrowed value. Above 1 is safe, below 1 can be liquidated. With 1 ETH at $3,600 as collateral, an 82.5% liquidation threshold and $2,600 borrowed, the health factor is 1.14, and liquidation starts if ETH falls to about $3,152.
The formula
Health factor = (Collateral value x Liquidation threshold) / Borrowed value| Term | Meaning |
|---|---|
| Collateral value | What your deposited assets are worth right now |
| Liquidation threshold | The share of collateral value at which the loan counts as undercollateralised, set per asset (often 75 to 85% for ETH) |
| Borrowed value | What you owe, including interest that has built up |
| LTV (loan to value) | The maximum you can borrow when opening the loan. It is lower than the liquidation threshold, which gives you a buffer. |
A common mistake, which this post made in its first version, is using LTV in the formula. LTV only caps how much you can borrow. Liquidation is based on the threshold.
Worked example
| Start | After ETH drops | |
|---|---|---|
| ETH price | $3,600 | $2,500 |
| Collateral (1 ETH) | $3,600 | $2,500 |
| Liquidation threshold | 82.5% | 82.5% |
| Borrowed (USDC) | $2,600 | $2,600 |
| Health factor | 3,600 x 0.825 / 2,600 = 1.14 | 2,500 x 0.825 / 2,600 = 0.79 |
At 0.79 the position can be liquidated. Solving for a health factor of exactly 1 gives the liquidation price:
Liquidation price = Borrowed / (Collateral amount x Liquidation threshold)
= 2,600 / (1 x 0.825) = about $3,152So a 12% drop in ETH, from $3,600 to about $3,152, is enough. That is a normal day in crypto.
What happens at liquidation
When the health factor falls below 1, anyone can repay part of your debt and take some of your collateral at a discount, the liquidation bonus (often 5 to 10%). On Aave, up to half of the debt can be liquidated in one go. You keep the borrowed money but lose more collateral than the debt that was repaid.
How to keep a position safe
- Aim for a health factor of 1.5 to 2 or more, not just above 1.
- Know your liquidation price and set a price alert above it.
- Add collateral or repay part of the loan when the health factor falls, before it reaches 1.
- Remember interest: debt grows over time, so the health factor drifts down even if prices do not move.
- Be careful with volatile collateral against stablecoin debt; that is exactly the setup in the example.
Also check your wallet's token approvals regularly. See why people say revoke after a wallet hack. For more on the risks of chasing crypto rewards, read can you survive as a full-time airdrop hunter.
Frequently asked questions
What is a good health factor in DeFi?
Anything above 1 avoids liquidation, but 1.5 to 2 or higher gives room for normal price swings. Below 1.2 is risky with volatile collateral.
How is the health factor calculated?
Multiply your collateral value by its liquidation threshold and divide by the value of what you borrowed. For example, $3,600 x 0.825 / $2,600 = 1.14.
What is the difference between LTV and liquidation threshold?
LTV is the maximum you can borrow when you open the loan. The liquidation threshold is the higher level at which the position can be liquidated. The gap between them is your safety buffer.
What happens when my health factor goes below 1?
Liquidators can repay part of your debt and take your collateral at a discount, called the liquidation bonus. You lose more collateral than the debt they repay.
How can I raise my health factor?
Deposit more collateral, repay part of the loan, or swap volatile collateral for a less volatile asset.
No comments:
Post a Comment
Comments are moderated. Questions and corrections are welcome; spam and promotional links are removed.