Most DeFi borrowers monitor price, loan-to-value, and health factor. Those are important, but they are not the only numbers that decide what happens when a position turns unsafe.
Two of the most consequential parameters usually get less attention: liquidation penalty and close factor. They sound technical, and because of that they are often ignored until the moment they start taking money out of a position.
The reason they matter is simple. Once a borrow becomes liquidatable, these settings determine two different things. Liquidation penalty determines how much value the liquidator can extract from the borrower’s collateral when repaying debt. Close factor determines how much of the debt can be repaid in one liquidation step.
That means one parameter shapes the cost of being liquidated, while the other shapes the speed and size of the cleanup.
Different protocols use different names for this concept. Some call it a liquidation penalty. Aave usually calls it a liquidation bonus, because the bonus is framed from the liquidator’s perspective. Compound v2 calls the same broad idea the liquidation incentive.
The borrower should read all three labels the same way. It is the discount at which collateral can be taken once the position has crossed into liquidation territory.
Suppose a liquidator repays $1,000 of debt on an underwater account. If the liquidation incentive or bonus is 5%, the liquidator may seize $1,050 worth of collateral. That extra $50 is the economic reward for doing the liquidation and taking execution risk.
From the protocol’s perspective, this reward is necessary. Liquidators need a reason to step in quickly during stress, especially when markets are falling and onchain execution can be competitive or costly. From the borrower’s perspective, it is a direct loss. Once liquidation starts, collateral is not sold at a fair mid-market transfer. It is handed over at a discount.
That is why liquidation penalty is not a cosmetic parameter. It directly affects recovery value after the position breaks.
Close factor answers a different question. Instead of asking how much the liquidator earns, it asks how much of the borrower’s debt can be repaid in a single liquidation action.
Compound v2 states this clearly in its cTokens documentation: a liquidator may close up to a certain fixed percentage, meaning the close factor, of any individual outstanding borrow of an underwater account. Aave uses a more dynamic model. It explains that up to 50% of total debt can usually be liquidated when the health factor is above 0.95 and the position is not small, while up to 100% can be liquidated when health factor is 0.95 or below, or when either the debt or collateral side is small enough to trigger dust-clearing rules.
This is the distinction that many users miss. A liquidation does not always mean the whole position gets wiped in one transaction. Sometimes the protocol only allows a partial reduction. Other times it allows the entire debt to be cleared immediately.
That difference matters because it shapes what a borrower has left after the first hit and whether the account can survive long enough to recover if market conditions stabilize.
Liquidation penalty and close factor are different controls, but they interact constantly.
A high penalty with a low close factor means each liquidation step is expensive for the borrower, but the protocol may need several liquidation steps to fully repair or clear the account. That can create repeated losses if the account remains underwater after the first partial liquidation.
A lower penalty with a higher close factor can be less punishing per dollar of debt repaid, but it also allows a much larger portion of the position to be cut away immediately. The borrower loses control faster, even if the discount per unit is smaller.
This is why it is a mistake to focus on only one of the two. A borrower who checks only liquidation bonus may underestimate how quickly a position can be dismantled. A borrower who checks only close factor may underestimate how much value leaks out each time collateral is seized.
The real liquidation experience is the product of both.
Aave is a useful example because it makes the close-factor idea more dynamic than many users expect. Its current liquidation guidance shows that the amount eligible for liquidation depends not only on whether the health factor is below 1, but also on how far below and on whether the position is large enough to justify a partial cleanup rather than full dust removal.
That means the liquidation path changes as the position worsens. A borrower hovering just below the threshold may lose part of the debt exposure. A borrower who keeps falling, or whose position becomes small enough that partial cleanup would leave unusable leftovers, can be fully cleared.
This matters because many users still think of close factor as one fixed protocol-wide number. In modern lending systems, it is often more conditional than that. Risk state matters.
Compound v2 is useful for explanation because its wording is very direct. The docs state that a liquidation occurs when a user has negative account liquidity, that the liquidator repays some or all of a borrow, and that the collateral is seized at a discount defined by the liquidation incentive. They then separate that from the close factor, which caps how much of a given borrow can be repaid in one action.
That clean separation helps show the mechanical difference.
Once those roles are separated, the borrower’s risk becomes much easier to understand.
Most interfaces simplify liquidation risk because too much detail overwhelms new users. The result is that borrowers become familiar with health factor as a single master number and stop there.
That shortcut is dangerous. Health factor only tells whether a position is safe or close to unsafe. It does not tell how painful liquidation will be after the threshold is crossed. Two positions with similar health factors can have meaningfully different liquidation outcomes if the assets involved carry different penalties or if the protocol allows deeper one-shot liquidations under certain conditions.
This becomes more important during market stress. When prices are moving quickly, borrowers do not have time to learn protocol mechanics on the fly. The users who already understand penalty and close factor know whether they are facing a shallow repairable hit or a fast, value-destructive unwind.
The better question is: what happens after liquidation starts.
If the close factor is modest, the first liquidation may only reduce part of the debt, leaving the account alive but damaged. If the market keeps moving against the borrower, more partial liquidations can follow. Each step can seize collateral at a penalty, compounding losses.
If the close factor becomes full at deeper distress, the account can move from repairable to largely finished in one sharp move. The borrower may lose the optionality to wait for a rebound.
Meanwhile, the liquidation penalty decides how much value disappears from the position during every one of those steps. A larger penalty makes recovery harder because the borrower loses more collateral than the face value of the debt being repaid.
That is why the familiar phrase liquidation event understates what is actually happening. It is a rules-based transfer of value from a distressed position to the actors willing to stabilize it.
A useful checklist starts with the collateral asset itself. On protocols such as Aave, liquidation threshold and liquidation bonus are defined per reserve, which means different collateral assets can expose borrowers to different liquidation economics. Then the borrower should check whether the protocol uses a static or state-dependent close factor. On Compound v2, the concept is straightforward and fixed in the risk model. Aave’s close-out size depends on how deep the distress is and whether dust rules apply.
After that, the user should stop thinking in percentage terms alone and run an actual scenario. If a position falls below threshold, how much debt can be repaid immediately, how much collateral can be seized, and what health factor would remain afterward. That exercise often reveals more risk than the UI’s summary numbers do.
Liquidation penalty and close factor are two of the most important lending parameters most users never check because they only become visible after a position is already in trouble. The penalty, whether called a bonus or incentive, determines how much collateral is lost to liquidators for each dollar of debt repaid. The close factor determines how much of that debt can be cleared in one step. Together they shape both the cost and the speed of liquidation. For borrowers, that is the real liquidation profile. Health factor may tell when danger begins, but these two parameters decide how expensive the damage becomes once the protocol starts enforcing its rules.
The post DeFi Lending Parameters: Liquidation Penalty vs Close Factor Explained appeared first on Crypto Adventure.
