Liquidation Penalty, Close Factor and Health Factor: How DeFi Lending Liquidations Work
The liquidation penalty and health factor are the two numbers that decide whether your borrowed position survives or gets sold out from under you in DeFi lending protocols like Aave and Compound. Your health factor is a single ratio that measures how safe your loan is relative to your collateral, and the liquidation penalty (often called the liquidation bonus) is the discount a liquidator earns for closing part of your debt when that ratio drops too low. Put simply: when your health factor falls below 1, anyone can repay part of your loan, seize an equivalent value of your collateral, and pocket a bonus that comes straight out of your pocket. This guide explains exactly how those mechanics work, walks through a real example, and shows you how to avoid getting liquidated.
Key Takeaways
- A health factor below 1 means your position can be liquidated by anyone watching the protocol.
- The close factor caps how much of your debt a single liquidation can repay at once, often 50 percent.
- The liquidation bonus, typically 5 to 15 percent, is the borrower's real cost, paid out as discounted collateral.
- A larger collateral buffer keeps your health factor high and gives you room before the threshold.
How the liquidation penalty and health factor are calculated
The health factor is the protocol's safety gauge for your loan. On Aave style protocols it is calculated as the sum of your collateral value multiplied by each asset's liquidation threshold, divided by your total borrowed value. Formally: health factor = (collateral in USD x liquidation threshold) / total debt in USD. The liquidation threshold is a percentage set per asset, for example 80 percent for a blue chip like ETH, that defines how much of that collateral can back debt before the position is considered unsafe.
When the result is above 1, your position is healthy and no one can touch it. When it sits exactly at 1, you are at the edge. The moment it drops below 1, your loan is eligible for liquidation. The ratio moves whenever prices move: if your collateral falls in value or the asset you borrowed rises, the numerator shrinks or the denominator grows, and the health factor declines. If you want to understand the full borrowing workflow first, see our step by step Aave borrowing tutorial.
The close factor: how much of your debt can be repaid at once
When your health factor drops below 1, a liquidator does not get to repay your entire loan in most cases. The close factor sets the maximum share of your outstanding debt that a single liquidation transaction can clear. On classic Aave V2 and Compound, this is commonly 50 percent, meaning a liquidator can repay at most half of your borrowed amount in one go and claim the matching collateral plus bonus.
This partial design is deliberate. By only closing part of the loan, the protocol gives the borrower a chance to recover if prices bounce, rather than wiping out the entire position on a brief dip. Newer versions add nuance: Aave V3 allows a 100 percent close factor when the health factor is very deep (for example below 0.95) or the remaining debt is tiny, so deeply underwater positions can be fully cleared in one transaction. The exact figure is a protocol parameter, so always check the version you are using.
The liquidation bonus and penalty paid to liquidators
The liquidation bonus is the incentive that makes anyone want to repay your debt for you. When a liquidator clears part of your loan, they receive your collateral at a discount, usually 5 to 15 percent below market price depending on the asset. That discount is the liquidator's profit and your loss. From the borrower's perspective it is a penalty, which is why the same number is described two ways depending on who is talking.
This bonus is the part that genuinely costs you. The repaid debt was money you owed anyway, but the discounted collateral handed to the liquidator is value you lose on top of settling the loan. A 10 percent bonus on a 5,000 dollar liquidation means roughly 500 dollars of your collateral evaporates as a reward to whoever triggered it. Understanding this is central to what liquidation in crypto really means and why protocols can stay solvent even during sharp crashes.
| Parameter | What it controls | Typical value |
|---|---|---|
| Health factor | Whether liquidation can happen | Liquidation triggers below 1.0 |
| Liquidation threshold | How much debt collateral can back | 75 to 85 percent for blue chips |
| Close factor | Max debt repaid per liquidation | 50 percent (up to 100 percent when deep) |
| Liquidation bonus / penalty | Discount paid to liquidator | 5 to 15 percent of collateral |
A worked example: from healthy to liquidated
Imagine you deposit 10,000 dollars of ETH as collateral, where ETH has an 80 percent liquidation threshold, and you borrow 6,000 dollars of USDC. Your health factor is (10,000 x 0.80) / 6,000 = 1.33. Comfortable, with room to move.
Now ETH drops 30 percent. Your collateral is worth 7,000 dollars and your debt is still 6,000 dollars. Health factor = (7,000 x 0.80) / 6,000 = 0.93. You are below 1, so you are liquidatable. A liquidator steps in under a 50 percent close factor and repays 3,000 dollars of your USDC debt. With a 10 percent liquidation bonus, they claim 3,000 dollars plus 10 percent, so 3,300 dollars of your ETH. That extra 300 dollars is your penalty. After liquidation you still owe 3,000 dollars, your remaining collateral is about 3,700 dollars, and your health factor recovers above 1. The position survives, but you lost 300 dollars purely to the bonus. For a deeper look at what happens when collateral cannot even cover the debt, read our DeFi liquidation versus bad debt analysis.
How to keep your health factor safe
The simplest defense is a generous collateral buffer. Borrowing far below your maximum keeps your health factor well above 1, so it takes a much larger price move to put you at risk. Many cautious users keep their health factor at 2 or higher on volatile collateral. You can also strengthen a position by supplying more collateral or by partially repaying debt before prices fall further, both of which push the ratio back up.
Choosing stable, high threshold collateral helps too, since a low threshold asset gives you less headroom for the same loan. Monitoring matters: set alerts, watch volatility, and act early rather than hoping a dip reverses. For broader context on what can go wrong with the assets you pledge, see our notes on collateral risks in DeFi lending, and for hands on practice review how to use Aave for lending and borrowing.
Why lending liquidations differ from perp and futures liquidations
It is easy to confuse the two, but they work differently. In DeFi lending, you over collateralize: you pledge assets worth more than you borrow, and liquidation sells part of that collateral to bring the loan back to safety. The penalty is the liquidation bonus, the position is usually only partially closed thanks to the close factor, and your liability is capped at your collateral in normal conditions.
Perpetual and futures trading is the opposite. There you post a small margin to control a much larger leveraged position, so liquidation closes the entire trade once your margin can no longer cover losses, and your loss is your margin rather than a discount on collateral. Lending liquidation is about restoring a collateral ratio; perp liquidation is about closing a leveraged bet before it goes negative. Knowing which mechanic you are exposed to tells you exactly which number, health factor or margin level, you need to watch.
This article is for educational purposes only and is not financial advice.