If you run out of cash and are thinking of withdrawing your mutual fund investments, take a break. There is another option: you can take out a loan with mutual funds as collateral and not interrupt the potential long-term profitability of your investment.
Several banks offer loans against mutual fund units at interest rates ranging from 10 to 15% per annum.
Eligibility
Many banks also have mutual fund branches, but you do not necessarily need to be an investor in the bank’s mutual fund scheme to avail this lending facility. Each bank has its own list of fund houses, with which they are willing to lend. If your fund comes from one of these houses, you can take a loan.
However, it is necessary to have a savings account with the bank. Also, the bank account and the mutual fund account must have the same PAN.
Typically, an equity mutual fund can borrow up to 50% of its value (loan-to-value ratio), while a debt mutual fund can borrow up to 75% of its value.
The process
You can apply for the loan through the bank’s website. You need to submit the mutual fund folio number, the name of the scheme, the total number of units you wish to pledge and the value of the units.
The details are vetted by the mutual fund transfer and registration agent, who 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 line, meaning you pay interest only on the amount used. The overdraft line is usually valid for 12 months and can be renewed.
Once your units have been marked for lien, they will not be available for redemption. Redemption will only be possible after the loan has been paid off and the lien has been released.
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When to take advantage of it?
It is best to apply for a mutual fund loan only for short periods and small amounts. These can be for when you need cash due to an emergency and you are sure you can repay the amount quickly.
“A client of mine recently took out an MF loan to make the down payment for his home purchase. In another case, a client had a medical emergency in the family,” said Rushabh Desai, Founder, Rupee, Rushabh Investment Services.
“Long-term loans are avoidable as you are then letting the loans eat into the profitability of the portfolio. Also, if you default on the repayment, you can lose part or all of the portfolio, depending on the units pledged,” Desai added.
When to avoid it
As mentioned, if you take out a loan with a stock mutual fund, you typically have to commit at least 50% of the loan value as margin. However, when markets become extremely volatile, this margin can quickly erode.
In such situations, the lender may ask you to increase collateral, i.e. pledge more mutual fund investments, or decide to sell some of your investments.
“While mutual fund-secured loans provide access to liquidity without the need to sell investments, market risk can lead to margin calls. Other risks, such as interest rate risk, may force you to pay a higher interest rate while servicing this loan,” said Ravi Kumar TV, Founder, Gaining Ground Investment Services.
If you have a sizable corpus of debt mutual funds, it would be better to use it as collateral as the margin requirement is usually lower at 25%.
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