Health Factor

The Health Factor is fundamentally a dynamic collateralization ratio. It is calculated as: HF = (Total Collateral Value * Collateral Factor) / Total Borrowed Value

• Collateral Factor (Loan-to-Value): The maximum percentage of an asset's value that can be borrowed against (e.g., ETH may have a 75% LTV).
• A higher HF indicates a larger safety buffer against liquidation.

The liquidation threshold is the critical Health Factor value, typically HF = 1.0, where a position becomes eligible for liquidation.

• HF > 1.0: Position is safe.
• HF ≤ 1.0: Position is undercollateralized and can be liquidated by other users to repay the debt, often incurring a liquidation penalty for the borrower. Protocols may use a buffer (e.g., HF < 1.1) to trigger warnings.

The Health Factor is highly sensitive to real-time price feeds from oracles. Since it's calculated using the current market value of collateral and debt assets:

• Volatility Risk: Rapid price drops in collateral (e.g., ETH) or spikes in borrowed assets can cause HF to plummet.
• Oracle Manipulation: A core security assumption is that oracle prices are accurate and resistant to manipulation, as incorrect prices can trigger unjust liquidations.

HF aggregates risk across a user's entire borrowing portfolio, not per asset.

• Cross-Collateralization: Users can supply multiple asset types as collateral (e.g., ETH, WBTC, UNI).
• Net Risk Calculation: The HF accounts for the weighted risk of the entire collateral basket and total debt across all borrowed assets. This allows for more capital efficiency but introduces interconnected risk.

HF is not static; it changes with market conditions and user actions. Key management levers include:

• Adding Collateral: Depositing more assets increases the numerator, raising HF.
• Repaying Debt: Reducing borrowed amount decreases the denominator, raising HF.
• Withdrawing Collateral: This decreases the numerator, lowering HF and increasing risk. Users must monitor HF actively to avoid liquidation.

While the core formula is consistent, each protocol implements unique parameters affecting HF:

• Collateral & Borrow Factors: Set by governance and vary by asset risk (e.g., stablecoins have higher factors than volatile assets).
• Liquidation Bonus: The discount liquidators receive, which impacts the effective liquidation threshold.
• Close Factor: On some protocols (e.g., Compound), limits how much debt can be liquidated in one transaction. Understanding these is crucial for risk assessment.

The Health Factor (HF) is computed as: HF = (Σ Collateral_i × Price_i × LTV_i) / (Σ Debt_j × Price_j). Key components are:

• Collateral Value: The total USD value of deposited assets.
• Loan-to-Value (LTV) Ratio: The maximum borrowing power for each collateral type (e.g., 80% for ETH).
• Borrowed Value: The total USD value of outstanding loans. A value above 1.0 indicates a safe position; below 1.0 triggers liquidation.

When the Health Factor drops below 1.0, the position becomes eligible for liquidation. Protocols set a Liquidation Threshold for each asset, which is lower than its LTV, creating a buffer. For example, an asset with an 80% LTV might have an 85% liquidation threshold. This means borrowing up to 80% is allowed, but liquidation risk begins when the borrowed value exceeds 85% of the collateral's adjusted value.

The Health Factor is governed by protocol-specific risk parameters set by decentralized governance (e.g., Aave's Risk Council, Compound's COMP holders). These include:

• LTV & Liquidation Threshold: Per-asset values defining borrowing limits and safety margins.
• Liquidation Bonus/Penalty: The discount liquidators receive when seizing collateral.
• Reserve Factors: Fees taken from interest to build a safety reserve. These parameters are dynamically adjusted based on market volatility and asset liquidity.

A user deposits 10 ETH as collateral (worth $30,000) and borrows 15,000 USDC. Assuming ETH has a 75% LTV:

• Adjusted Collateral: $30,000 × 0.75 = $22,500
• Health Factor: $22,500 / $15,000 = 1.5 If ETH's price drops to $2,500, the adjusted collateral becomes $18,750, and the HF falls to 1.25. A drop to ~$2,000 would push the HF below 1.0, triggering liquidation.

Compound uses a Collateral Factor (CF), which is functionally equivalent to the LTV in the Health Factor calculation. A user's borrowing limit is Σ (Collateral × CF). The key difference is in liquidation mechanics: Compound allows borrowing up to the CF, while Aave's LTV is the safe limit, with a separate liquidation threshold. Both systems aim to ensure the protocol remains over-collateralized.

The Health Factor (HF) is a numerical ratio that measures the safety of a collateralized debt position (CDP). It is calculated as:

Health Factor = (Total Collateral Value × Collateral Factor) / Total Borrowed Value

• Collateral Factor (Loan-to-Value Ratio): The maximum percentage of an asset's value that can be borrowed against (e.g., 80% for ETH).
• A higher HF (>1.0) indicates a safer position, while HF ≤ 1.0 triggers liquidation.

When the Health Factor drops to or below the protocol's liquidation threshold (typically 1.0), the position becomes undercollateralized and is eligible for liquidation.

• Liquidation: A third-party liquidator repays part or all of the debt in exchange for the collateral at a discount.
• Liquidation Penalty: An additional fee (e.g., 5-15%) is applied to the seized collateral, penalizing the borrower and incentivizing liquidators.
• The process is automated and designed to protect the protocol from bad debt.

The main risk to a Health Factor is asset price volatility. A sudden drop in collateral value or a spike in borrowed asset value can rapidly decrease the HF.

• Oracle Reliance: HF calculations depend entirely on external price oracles. Inaccurate or manipulated oracle data can cause incorrect HF readings and unfair liquidations.
• Liquidation Cascades: Mass liquidations in a volatile market can further depress collateral prices, triggering more liquidations in a feedback loop.

Users must actively monitor their Health Factor to avoid liquidation.

• Safety Buffer: Maintaining an HF significantly above 1.0 (e.g., >1.5) provides a buffer against market swings.
• Proactive Management: Users can improve their HF by:
  • Adding more collateral.
  • Repaying part of the borrowed amount.
• Automated Tools: Many protocols and third-party dashboards offer alerts for declining Health Factors.

While the core concept is universal, implementation details vary by protocol.

• Aave: Uses Health Factor with a liquidation threshold of 1.0. Also features a Liquidation Bonus for liquidators.
• Compound: Uses a similar metric called Collateral Factor to determine borrowing limits, with a separate Liquidation Incentive.
• MakerDAO: Employs a Collateralization Ratio for its Vaults, where the Liquidation Ratio is the critical threshold. Understanding the specific parameters of your chosen protocol is essential.

Health Factor interacts with other key risk parameters in a lending system.

• Loan-to-Value (LTV) Ratio: The inverse perspective of collateral factor; the debt amount relative to collateral value.
• Liquidation Threshold: The specific HF value at which liquidation begins.
• Maximum LTV: The highest LTV allowed when opening a position.
• Liquidation Fee/Penalty: The cost incurred by the borrower upon liquidation. Together, these create the protocol's risk framework.

Also known as the collateralization ratio, this is the maximum proportion of an asset's value that can be used to secure a loan. It is the inverse of the Loan-to-Value (LTV) ratio. A 75% LTV equals a 133% collateral factor (1 / 0.75). This factor directly influences the Health Factor calculation by determining how much borrowing power each unit of collateral provides.

The fundamental security model of most DeFi lending, where the value of the collateral posted exceeds the value of the loan. The Health Factor is a dynamic measure of this overcollateralization.

• Purpose: Mitigates price volatility risk without requiring credit checks.
• Mechanism: A Health Factor > 1.0 indicates the loan is overcollateralized. A factor < 1.0 means it is undercollateralized and subject to liquidation.

Incentive programs where users supply or borrow assets to earn protocol tokens. These activities directly impact Health Factor risk.

• Borrowing to Farm: Users may take on debt (lowering their Health Factor) to deposit borrowed assets into a farm, creating leveraged yield farming positions.
• Risk Amplification: This strategy significantly increases liquidation risk if asset prices move against the borrower.