The Health Factor reflects the safety of your debt position against liquidation.
A Health Factor above 1 means your deposited collateral outweighs your debt. Conversely, a Health Factor below 1 signals a risky position where your collateral is valued lower than your debt. In such cases, your collateral may be liquidated to repay the debt and uphold the protocol's solvency.
Calculation of Health Factor
Health Factor=Value of Borrowed amountValue of Collateral×Liquidation Threshold
The Health Factor is calculated as the value of your assets multiplied by a liquidation threshold, and dividing that total by the value of your borrowed assets. This threshold provides a safety buffer against the volatility risk of the collateral.
The price of ETH is $2000, and with a liquidation threshold of 0.75, if Alice borrowed $1000, the Health Factor is calculated as follows:
Liquidation happens when your Health Factor drops below 1. Changes in the value of your supplied collateral and borrowed assets can affect your Health Factor, so it's important to monitor your debt position closely to avoid this.
If the value of your supplied collateral is less than your borrowed amount, Pike faces the risk of not having enough funds to repay its depositors. To safeguard the protocol, market arbitrageurs will close your debt position by selling your supplied collateral to pay off the debt. This process is known as liquidation.
In the earlier example involving Alice, assuming the price of ETH falls to $1000, the Health Factor will fall below 1, and is calculated as follows:
In this scenario, liquidators will sell Alice’s ETH for USD and use the proceeds to repay Alice's debt, thereby restoring the Health Factor to above 1. Additionally, liquidators will collect a liquidation fee during this process.
To avoid a forced liquidation, borrowers must ensure their Health Factor remains above 1. Borrowers can either supply additional assets or repay their debt to increase their Health Factor.
A higher Health Factor provides greater resilience against market volatility. For example, a Health Factor of 2 offers protection against a 50% drop in collateral value.