Loan-to-Value Ratio (LTV)

The Loan-to-Value (LTV) ratio is the primary metric for assessing the risk of a collateralized loan. It is calculated as (Borrowed Amount / Collateral Value) * 100%. A lower LTV indicates a larger safety buffer for the lender, while a higher LTV signifies increased risk of liquidation if the collateral value falls.

Each lending protocol sets a Maximum LTV for every supported asset, acting as a hard borrowing limit. For example, if ETH has a 75% Max LTV, a user depositing $10,000 worth of ETH can borrow up to $7,500 of another asset. This cap is determined by the asset's volatility and liquidity to protect the protocol's solvency.

The Liquidation Threshold is a critical LTV level, always set higher than the Maximum LTV. If a position's LTV exceeds this threshold due to collateral depreciation or debt appreciation, it becomes eligible for liquidation. For instance, with an 80% threshold, a position at 82% LTV can be liquidated to repay the debt, protecting the protocol from bad debt.

The Health Factor is the inverse metric derived from LTV, representing a position's safety margin. It's calculated as (Collateral Value * Liquidation Threshold) / Borrowed Amount. A Health Factor above 1.0 is safe; below 1.0 triggers liquidation. Users monitor this to manage risk, often adding collateral or repaying debt to increase their buffer.

LTV parameters are not static. Decentralized Autonomous Organizations (DAOs) or protocol governance can vote to adjust Maximum LTV and Liquidation Thresholds based on market conditions. For highly volatile assets, LTVs are set lower (e.g., 50-65%), while stable, liquid assets like wrapped Bitcoin (WBTC) may have higher LTVs (e.g., 70-80%).

In DeFi, LTV is enforced automatically by smart contracts in real-time, unlike traditional mortgages. There is no credit check; risk is managed solely via over-collateralization and automated liquidations. This allows for permissionless, global access to credit but requires active position management by the borrower to avoid liquidation events.

The Loan-to-Value (LTV) ratio is a percentage calculated as (Loan Amount / Collateral Value) * 100. It quantifies the risk exposure of a lending position. A lower LTV indicates a larger safety buffer, while a higher LTV brings the position closer to the liquidation threshold, the point at which the collateral can be automatically sold to repay the loan.

Protocols set a maximum LTV ratio (e.g., 80% for ETH) and a higher liquidation threshold (e.g., 85%). The Health Factor is a derived metric (Collateral Value / (Loan * Liquidation Threshold)). If this factor falls below 1.0, the position becomes eligible for liquidation. This system creates a buffer zone between the maximum borrowable amount and the point of automatic asset seizure.

The principal risk of a high LTV is liquidation due to price volatility. If the collateral asset's value drops significantly, the LTV rises. Once it crosses the liquidation threshold, liquidators are incentivized to repay part of the debt in exchange for the collateral at a discount, resulting in a loss for the borrower. This process is automated and can occur within minutes during market crashes.

LTV ratios and liquidation thresholds are governance parameters that can be changed via protocol governance. A sudden reduction in the maximum LTV for an asset can force borrowers to either deposit more collateral or repay part of their loan to avoid liquidation. This represents a non-market risk that borrowers must monitor.

LTV calculations depend entirely on price oracles (e.g., Chainlink). If an oracle provides stale or manipulated price data, it can cause inaccurate LTV calculations. This could lead to unjustified liquidations (if the price is reported too low) or allow undercollateralized positions to persist (if the price is reported too high), threatening protocol solvency.

• Maintain a low LTV: Borrow significantly less than the maximum allowed to create a buffer against volatility.
• Monitor positions actively: Use tools to track your Health Factor, especially during high market volatility.
• Understand the assets: Use less volatile assets as collateral where possible.
• Have a repayment plan: Ensure you have access to funds or stablecoins to add collateral or repay debt quickly if needed.

The Liquidation Threshold is the specific LTV level at which a loan becomes undercollateralized and can be liquidated. If a protocol has an LTV of 75% and a Liquidation Threshold of 80%, a loan is safe below 75% LTV, at risk between 75-80%, and subject to liquidation above 80%. This buffer protects the protocol from instant losses due to price volatility.

A Health Factor (HF) is a dynamic, real-time metric used by protocols like Aave and Compound to represent a position's safety. It is calculated as (Collateral Value * Liquidation Threshold) / Loan Value.

• HF > 1: Position is safe.
• HF <= 1: Position is undercollateralized and can be liquidated. Health Factor decreases as LTV increases or collateral value drops.

Maximum LTV is the highest Loan-to-Value ratio at which a new loan can be initiated or an existing loan can be borrowed against. It is a protocol-defined risk parameter that varies by asset based on volatility and liquidity. For example, stablecoins like USDC may have a Max LTV of 85%, while a more volatile asset like ETH may have a Max LTV of 75%.

Overcollateralization is the foundational risk mitigation practice in DeFi lending where the value of the collateral deposited exceeds the value of the loan issued. An LTV of less than 100% (e.g., 70%) means the loan is overcollateralized by 30%. This buffer absorbs market fluctuations, protecting lenders from loss if the borrower defaults and the collateral is liquidated.

Liquidation is the process of forcibly selling a borrower's collateral to repay their loan when the LTV breaches the protocol's Liquidation Threshold (Health Factor <=1). A liquidation penalty is applied, and liquidators are incentivized with a discount on the collateral. This mechanism ensures the protocol remains solvent, making LTV a critical trigger for this event.