Loans against mutual funds: Should you opt for it over a personal loan?

A loan against mutual funds significantly reduces the short-term borrowing (less than one year) cost

If you are short on cash and urgently require funds, don't get tempted to redeem your mutual fund units or break that fixed deposit.  You can instead opt for a lesser-known alternative that allows you to access funds without sacrificing the growth potential of your investments through the Loan against Mutual Funds’ (LAMF) route. 

A loan against securities is a type of secured loan that allows borrowers to pledge their securities, including stocks, mutual funds, bonds, or other financial assets as collateral to acquire a loan from a bank or non-banking financial corporation. 

"This loan type enables individuals to access funds without having to liquidate their investments. To pledge shares of companies, they must be approved by the capital market regulator and not banned or delisted from stock exchanges. The same goes for mutual fund units, which should not be in a segregated scheme by the fund house upon some default.," said Adhil Shetty, CEO of BankBazaar.

Loans against mutual funds have become easy to access with the digitization of the entire loan process. This facility helps mutual fund investors to retain their systematic investment plans / Mutual funds, which they would have planned for long-term asset creation at 15-18 per cent returns.

"Investors can use the loan against the mutual fund for any short-term emergencies by pledging their asset with an interest cost of 10-11per cent per annum," said Bejoy Anthraper, Business Head of Geojit Credits.
 

What you should know about taking a loan against your securities.

1. Your shares and equity mutual funds should be in demat form. You must remember that once you avail the loan on securities, pledged shares or mutual fund units are under lien. It means you can't take any trade or sell calls until you repay the loan.

2. Depending on the lender, the loan amount is normally between 50 per cent and 80 per cent of the value of your holdings which you pledge as collateral.

"Several NBFCs and fintech companies readily provide 50-80per cent of the mutual fund value for loans without heavy documentation. Currently, these loans are available for a 9-11per cent interest rate compared to personal loans ranging between 12-15 per cent or even higher," said  Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.

If an investor borrows Rs 10 lakh at 12 per cent per annum personal loan, the EMI and total outgo will be Rs 96,451 and Rs 10.60 lakh. Instead, if she takes a loan against a mutual fund at 9per cent for 11 months, her EMI and total outgo will be Rs 10.45 lakh. So, she saved Rs 15,000, explained Kulkarni.

3. The minimum loan one can avail through this route is Rs 1 lakh, which goes up to a maximum of  Rs 20 lakh. You may be charged an interest in the range of 9-15 per cent per annum. However, you are liable to pay interest only on the amount utilised.

"For example, if you get Rs 5 lakh as an overdraft on your account and you use Rs 2 lakh and deposit the same in your account in one month, you are liable to pay interest only for one month on Rs 2 lakh," said Shetty..

4. Popular unsecured loans like personal loan have preclosure charges , whereas loan against mutual fund doesn't charge preclosure charge or part payment charges to borrowers.

"Since this is a secured loan, lenders are quite flexible by waiving off all pre-closure/ part payment charges, whereas they charge only the funds utilized Compared to personal loan or any other loans in the market, loan against mutual fund processing time is as low as 30-60 minutes," said Anthraper.

5. Just like personal loans, LAMF do not come with any end usage restrictions, except for illegal or speculative activities. LAMF borrowers would continue to receive the credit of dividends, bonuses, interest, etc. on their pledged mutual funds during the loan tenure.

6. Loan against mutual funds is usually offered in the form of an overdraft wherein a credit limit is sanctioned to the borrower on the basis of the market value and the LTV ratio set for the mutual fund. 

"The LTV ratio would depend on the asset class of the fund and its credit risk assessment made by the lender, subject to the caps on the LTV ratio set by the RBI. For example, the RBI guidelines have capped the LTV ratios for equity mutual funds at 75per cent. However, in case of debt-oriented funds, the lenders are free to set their LTV ratios," said Sahil Arora, Chief Business Officer (Unsecured Loans), Paisabazaar.

7. As with any other overdraft facility, LAMF would allow the borrowers to draw from their sanctioned limit as per their requirements. They can keep drawing from the sanctioned limit and make repayments as many times till the maturity of their overdraft facility. The interest component is calculated on the drawn amount till its repayment and not on the sanctioned limit. However, LAMF borrowers are usually required to service the interest component on a monthly basis. No prepayment charges are levied on making principal repayments. Moreover, borrowers also have the option of renewing their LAMF overdraft facility after the tenure expiry, subject to the approval of the lender.

" As the lenders have the option to redeem the pledged securities in case of defaults, they have a more relaxed approach towards credit score while evaluating loan applicants," said Arora.

8. Risks: As mutual funds primarily invest in market-linked instruments like equity shares, bonds, money market instruments, etc, their unit prices are susceptible to market fluctuations. 

"Lenders usually revalue the pledged mutual funds at periodical intervals. Lenders may also undertake interim revaluation of the pledged MFs during periods of steep market corrections or bearish markets. As the credit limit in LAMF is primarily determined on the basis of the market valuations of pledged funds, any sharp fall in the NAV of those funds may lead the total borrowed amount to exceed the set LTV ratio. In such situations, the lender would ask the LAMF borrowers to pledge more fund units or pay in cash/cheque to bring back the LTV ratio to the required levels. On failing to do so, lenders may levy penal interest or even liquidate the pledged funds," said Arora.

The list of approved mutual funds and their LTV ratios varies across lenders depending on their credit risk assessment. Thus, mutual fund investors should find out whether their investments are included in the lists of approved funds of various lenders. If their funds are listed, then they should compare the LTV ratios set by various lenders. 

Investors having higher credit scores should also compare the interest rates of personal loan overdraft facilities available on their credit profile before applying for LAMF. They should opt for the facility that costs them the least after factoring in interest rates, processing fees and other charges.
 

As per RBI data, loans against market securities are the smallest part of the personal credit pie at just 0.16 per cent of all outstanding loans. It’s also growing at the slowest rate. Loans against FDs (2.83 per cent) are much more popular and growing more quickly.