Introduction

Borrowing in DeFi can be a powerful strategy for leveraging your assets, but it requires careful management to avoid liquidations and maximize efficiency. This guide covers best practices for managing your DeFi debt positions across protocols.

Understanding Health Factors

The most critical metric for any borrower to monitor is their position's health factor:

• What it is: A numerical representation of how close your position is to liquidation
• How it's calculated: Typically (Collateral Value × Liquidation Threshold) ÷ Borrowed Value
• Safe ranges: Most experts recommend maintaining a health factor of at least 1.5-2x

Different protocols display health factors differently:

• Aave shows it directly as a numerical value
• Compound uses a similar concept with "account liquidity"

Collateral Strategy

Your choice of collateral significantly impacts your borrowing strategy:

Stable vs. Volatile Collateral

• Stable collateral (like stablecoins)

  • Lower liquidation risk
  • Lower LTV (loan-to-value) ratios typically allowed
  • Potentially lower yields

• Volatile collateral (like ETH or BTC)

  • Higher liquidation risk
  • Potential for appreciation alongside your loan
  • Typically higher yields in farming strategies

Diversification

• Multiple collateral types can reduce concentrated risk
• Multiple platforms can reduce protocol-specific risks
• Consider correlation between collateral assets

Optimizing Loan-to-Value Ratios

Finding the right LTV ratio is a balancing act:

• Conservative (30-50%): Lower risk of liquidation, but less capital efficiency
• Moderate (50-65%): Balanced approach for most users
• Aggressive (65-75%): Maximum capital efficiency, but higher liquidation risk

Your optimal LTV depends on:

• Volatility of your collateral
• Your risk tolerance
• Your ability to monitor and manage positions
• Market conditions

Liquidation Prevention Strategies

Set Up Monitoring and Alerts

• Use platform notifications if available
• Set up third-party monitoring tools like DeFi Saver
• Create price alerts on exchanges or portfolio trackers

Prepare Emergency Response Plans

• Keep some stablecoins readily available as "rescue funds"
• Understand how to quickly add collateral or repay debt
• Know which DEXs offer the best liquidity for your assets

Automate When Possible

• Use services that automatically adjust collateral or debt
• Consider protocols with automatic liquidation protection features
• Set up recurring collateral additions if your income is regular

Tax Considerations

Borrowing instead of selling can have tax advantages, but creates complexities:

• In many jurisdictions, borrowing is not a taxable event
• Interest paid is not typically tax-deductible for personal DeFi loans
• Keep detailed records of all borrowing activity
• Consult with a crypto-knowledgeable tax professional

Protocol-Specific Optimizations

Aave

• Utilize E-Mode for correlated assets to increase borrowing capacity
• Consider using GHO stablecoin for discounts with AAVE staking
• Understand how reserve factors affect long-term borrowing costs

Compound

• Monitor COMP rewards which can offset borrowing costs
• Understand the implications of cToken exchange rates
• Be aware of Compound's unique liquidation mechanism

Advanced Strategies

Rate Switching

• Monitor rate types - Many protocols offer variable and stable rates
• Switch opportunistically between rate types as market conditions change
• Use historical rate data to inform decisions

Leverage Cycles

• Use borrowed assets to generate yield
• Use generated yields to pay down principal
• Carefully calculate if yields reliably exceed borrowing costs

When to Refinance Debt

Consider moving debt between protocols when:

• Interest rate differentials exceed transaction costs
• Health factor improvements justify the move
• Special incentives make one protocol more attractive
• Risk parameters change significantly

Conclusion

Effective DeFi debt management requires vigilance, planning, and understanding of protocol mechanics. By implementing these best practices, you can minimize your risk of liquidation while maximizing the efficiency of your capital.

Remember that market conditions change rapidly in crypto, so regular review and adjustment of your debt positions is essential. Tools like Kapan Finance can help automate many of these optimizations, but the underlying principles remain important to understand.

The most successful DeFi borrowers are those who approach debt not just as a necessity but as a strategic tool that, when wielded carefully, can significantly enhance their overall portfolio performance.