If you run short of cash and plan to withdraw your mutual fund investments, take a pause. There is another option: You can take a loan against mutual funds and not disrupt the long-term potential compounding of your investment.
Several banks offer loans against mutual fund units at interest rates ranging from 10-15% per annum.
Eligibility
Many banks also have their mutual fund subsidiaries. But you don’t necessarily need to be an investor in the bank’s mutual fund scheme to avail of this loan facility. Every bank has its own list of fund houses, against which they are willing to lend. If your fund is from one of these houses, you can take a loan.
However, you need to have a savings bank account with the bank. Also, the bank account and the mutual fund account should have the identical PAN.
Typically, an equity mutual fund can fetch 50% of its value as a loan (loan-to-value ratio), while a debt mutual fund can fetch 75% of its value as a loan.
The process
You can avail of the loan from the bank’s website. You must submit the mutual fund folio number, name of the scheme, the total number of units you want to pledge and the value of the units.
The details are vetted by the mutual fund registrar & transfer agent, which maintains records of all mutual fund transactions, and a lien is marked against the units pledged as collateral. A lien is a legal claim or right made against an asset held as collateral.
The bank then sets up an overdraft facility. This means you pay interest only on the amount utilised. The overdraft facility is typically valid for 12 months and can be renewed.
Once your units have been marked for lien, they are not available for redeeming. Redemption is possible only after the loan is repaid and the lien is released.
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When to avail
Ideally, go for a loan against mutual funds only for short tenures and small amounts. These can be for when cash is needed due to an emergency, and you are certain you can repay the amount quickly.
“A client of mine recently took a loan against MF for making a downpayment for his house purchase. In another case, a client had a medical emergency in the family,” said Rushabh Desai, founder of Rupee with Rushabh Investment Services.
“Longer-tenure loans are avoidable as then you are just letting the loans eat into your portfolio returns. Additionally, if you default, you can lose the portfolio partly or fully, depending upon the units pledged,” Desai added.
When to avoid
As mentioned, if you take a loan against an equity mutual fund, you need to typically pledge at least 50% of the loan value as margin. However, when the markets turn extremely volatile, this margin can be eroded quickly.
In such situations, the lender can ask you to either add to the collateral, i.e. pledge more mutual fund investments, or decide to sell part of your investments.
“While loans against mutual funds give access to liquidity without selling off investments, market risk can trigger margin calls. Other risks like interest rate risk can force you to pay a higher rate of interest while you service this loan,” said Ravi Kumar TV, founder of Gaining Ground Investment Services.
If you have a sizeable debt mutual fund corpus, it would be better to use that as collateral, as the margin requirement is usually lower at 25%.