Lending Protocols: Understanding Health Factor in DeFi

Decentralized Finance (DeFi) has revolutionized the financial ecosystem, enabling anyone with an internet connection to access a broad range of financial services. Among these services, borrowing and lending have gained significant traction. However, managing your borrowing effectively is crucial to avoid liquidation risks, and understanding your Health Factor (HF) is key to navigating this landscape safely.

What is the Health Factor (HF)?

The Health Factor is a dynamic metric that determines the safety of your loan in a lending protocol. It reflects the relationship between your collateral’s value, the borrowed amount, and the platform’s Loan-to-Value (LTV) ratio.

Key Components of HF

• Collateral Value: The total value of assets supplied as collateral.
• Borrowed Amount: The total value of assets borrowed against the collateral.
• Platform’s LTV Ratio: The maximum percentage of collateral value you can borrow.

General Guidelines

• HF > 1.0: Safe zone; your collateral sufficiently covers the borrowed amount.
• HF = 1.0: Risk zone; any decrease in collateral value can trigger liquidation.
• HF < 1.0: Liquidation zone; the protocol may sell your collateral to recover the borrowed amount.

How Does Health Factor Work?

Let’s illustrate with a practical example:

• ETH Price: $3,600
• Collateral Supplied: 1 ETH ($3,600)
• LTV Ratio: 80% → Maximum Borrowable: $2,880 USDC
• Borrowed Amount: $2,600 USDC
• Initial HF: 1.11

Calculation:

Health Factor (HF): $\text{HF} = \frac{\text{Collateral Value} \times \text{LTV}}{\text{Borrowed Amount}} = \frac{3600 \times 0.8}{2600} = 1.11$ HF

Price Drop Scenario

• Now, if the price of ETH drops to $2,500:
• New Collateral Value: $2,500 (1 ETH × $2,500 = $2,500)
• New Maximum Borrowable: Collateral Value×LTV=2,500×0.8=2,000 USDC

Calculation of New Health Factor

Health Factor (HF): $\text{HF}=\frac{\text{Collateral Value}\times \text{LTV}}{\text{Borrowed Amount}}=\frac{2500\times 0.8}{2600}=\mathrm{0.77\; HF}\mathrm{<br>}\mathrm{<br>}$

Since the HF has dropped below 1.0, liquidation is triggered. The protocol will sell a portion of your collateral to restore balance.

How to Stay Safe in DeFi Lending

1. Borrow Less Than Maximum: Maintain a buffer to safeguard against market volatility. Borrowing the maximum makes your position highly vulnerable to even minor price changes.
2. Monitor Asset Prices: Regularly track the market value of your collateral. Price fluctuations directly impact your HF, and early action can prevent liquidation.
3. Actively Manage Your Position: 

• Increase your collateral when prices decline.
• Repay part of the loan to lower your borrowed amount.

Key Takeaways

• Always keep your HF well above 1.0 to avoid liquidation.
• Use alerts or tracking tools to monitor your positions in real-time.
• Diversify your collateral to reduce dependency on a single asset’s performance.

Disclaimer

I am not a financial advisor. The content shared here is for informational and educational purposes only and does not constitute financial, legal, or investment advice. Cryptocurrency investments carry risks, including the loss of principal & illegal in Nepal. Always do your own research and consult with a professional advisor before making any investment decisions.