Gold loan: Avoid maxing out on loan limit, maintain 20% valuation buffer

EMI-based repayment steadily reduces the principal and lowers LTV, offering better protection against price volatility than the bullet option

Bank loans against gold surged 125 per cent as of November-end from a year earlier, according to Reserve Bank of India (RBI) data. The RBI has flagged concerns over rising volatility in gold prices and advised lenders to exercise caution in the gold loan segment. In this environment, borrowers must be careful about how much they borrow and how they structure their loans. 

Loan eligibility rising 

Gold loans are sanctioned as a percentage of the pledged gold’s value. As gold prices rise, the same quantity of gold qualifies for a higher loan amount. “Our internal analysis shows that average ticket sizes have risen by about 20–25 per cent over the past year,” says Adhil Shetty, chief executive officer (CEO), BankBazaar. 

Regulatory limits apply to how much can be lent. “Lenders can only lend up to 75 per cent loan-to-value (LTV), according to Reserve Bank of India norms. Even if gold prices rise sharply, this cap cannot be breached,” says Harsh Vira, chief financial planner and founder, FinPro Wealth. (This limit will change from April 1, with higher percentages being allowed for smaller loans.) 

High borrowing raises risks 

Higher gold prices do not automatically raise the risk of margin calls. “Higher gold prices increase the collateral value of the pledged gold, improving loan security,” says Prasanna Pathak, managing partner, The Wealth Company. 

The risk arises when gold prices correct sharply, which can happen in the short run. “This can happen due to changes in global interest rates, currency movements, or geopolitical issues,” says Colin Shah, managing director, Kama Jewelry.

 

Risk increases when borrowers take loans close to the maximum permissible limit. “BankBazaar data show that gold loans taken at LTV above 65–70 per cent are far more vulnerable during periods of price volatility,” says Shetty.

 

Gold loans are revalued periodically using current market prices. “If falling gold prices push the loan-to-value ratio above the permitted limit, lenders may issue margin calls or ask for partial repayment,” says Vira.

 

Demand for additional cash, collateral 

Lenders may ask borrowers to repay part of the loan or provide additional gold when a sharp or sustained fall in prices pushes LTV beyond permissible limits. “Our data show that such requests typically arise when gold prices fall by 15–20 per cent or more from the valuation date,” says Shetty.

 

For instance, a borrower who pledges gold worth about 10 lakh and takes a loan of about 7.5 lakh at 75 per cent LTV will see the ratio jump to nearly 94 per cent if gold prices fall 20 per cent and collateral value drops to about 8 lakh. To restore the ratio, the borrower may need to repay about 1.5 lakh or pledge additional gold of similar value.

 

Triggers for auction 

Besides a fall in the price of gold, non-compliance by borrowers also plays a part in pledged gold being auctioned. “Lenders move to auction only after borrowers ignore margin calls and miss repayment periods beyond the permitted grace period,” says Shetty.

 

If dues remain unpaid despite repeated notices, lenders auction the pledged gold to recover principal, interest, penalties and recovery costs.

 

Gold loans are often structured as bullet repayment—quarterly, half-yearly, or yearly. “Lenders also initiate auction proceedings when borrowers default on these bullet instalments,” says Pathak.

 

Once an account turns overdue, lenders issue notices specifying timelines for repayment. “The borrower is allowed to repay the outstanding amount during the notice period and stop the auction,” says Pathak. Lenders typically provide about 15 days’ notice before an auction. “Borrowers can redeem their gold at any time up to the auction date, including on the auction day, by clearing all dues,” says Shetty.

 

Maintain valuation buffer 

Borrowers should avoid taking the maximum loan amount permitted. “Limit the amount borrowed to less than 80 per cent of the permitted amount to avoid triggering a margin call. This would allow a safety margin of at least 20 per cent, ensuring that even if gold prices correct by, say, 15 per cent, the gold pledged as collateral remains safe from liquidation,” says Abhishek Kumar, Sebi-registered investment adviser and founder, SahajMoney.com.

 

Shah also recommends a 10–20 per cent buffer. “Borrowing conservatively reduces stress during repayment and also lowers the risk of facing an auction in unstable markets,” he says.

 

Repayment option affects risk level 

Bullet repayments carry higher risk as interest compounds, while collateral value may fall if the price corrects. “In contrast, EMI-based payment options help in gradually reducing the principal balance every month, which automatically lowers the LTV ratio and protects the borrower from price volatility,” says Kumar.

 

However, the choice of repayment option must also align with cash flows. “Non-EMI-based repayment options like bullet repayment suit borrowers who have income and cash flow uncertainty that can lead to repayment constraints through EMIs. However, the interest cost for EMI-based payments is usually much lower than for non-EMI-based options,” says Santosh Agarwal, chief executive officer, Paisabazaar.

 

False sense of security 

Rising gold prices create a wealth effect among owners, who then use this asset to borrow. “Borrowers make the mistake of equating their EMI payment capacity with the asset’s liquidation value, rather than their own personal cash flow. The loan becomes difficult to manage when the price dips and could lead to a debt trap,” says Kumar.

 

Many borrowers assume gold prices will always remain high and hence borrow heavily. “Many borrowers also delay repayments or use gold loans for non-essential purposes instead of real needs,” says Shah.

 

Exercise caution 

Before pledging jewellery, borrowers should fully understand the punitive terms and conditions of their loan. “It is critical to fully understand the loan terms, including the interest rate, repayment period, auction triggers, and penalty clauses,” says Shah.

 

Borrowers should also check the lender’s valuation method. “Some non-banking financial companies may aggressively value gold at peak daily rates rather than the safer 30-day average method. If the price of gold goes down, then such a valuation method increases the risk of liquidation,” says Kumar. He advises keeping loan tenures between six and 12 months to minimise exposure to long-term price cycles.

 

It is also prudent to deal only with regulated lenders. Finally, Agarwal cautions against over-leveraging, suggesting that people borrow only the amount they need and can comfortably pay back.

 

The writer is a Mumbai-based independent journalist

 

Precautions borrowers must exercise

• Understand interest and penalties
• Know the conditions under which pledged gold can be auctioned
• Borrow only from regulated lenders
• Have a clear repayment plan; don’t rely on gold prices rising
• Keep loan tenure short, ideally 6–12 months, to avoid getting caught in long-term price cycles