Understanding The Functioning Of Loan Against Mutual Funds

Loan against mutual funds is a viable option for meeting short-term financial needs without liquidating your investments. They tend to be more cost-effective compared to personal loans and credit card loans, offering flexibility to repay early without foreclosure charges and charging interest only on the withdrawn amount. However, there are some drawbacks to consider. Rakesh Deshmukh will help you explore these in detail. 

It is quite possible that you may have faced an emergency requiring money. In such cases, options include asking friends and relatives, obtaining a personal loan from a bank, using a credit card, credit limits, or overdraft facilities. You likely considered these methods to arrange cash. Generally, not everyone has overdraft facilities and the problem with credit card loans is that if you don’t pay the bills on time, it can cost a lot, with interest rates reaching up to 18 to 25 per cent. 

Another commonly opted choice is a personal loan from a bank where nowadays the loan amount gets credited into to your bank account within a minute. However, both of these options have drawbacks. These methods of arranging cash are unsecured loans, meaning the risk of default is higher than that of secured loans. In investment terms, higher risk usually demands higher returns, and similarly, banks charge higher interest rates for unsecured loans compared to secured loans. 

Collateral loans or mortgage loans are commonly known types of secured loans. In these loans, borrowers typically pledge property as collateral to obtain the loan. In the case of a collateral or mortgage loan, the bank or lender has the right to sell the collateral property only if the borrower defaults on the loan. A loan against mutual funds is kind of similar to it. Let’s explore the concept. 

Loan Against Mutual Funds (LAMFs)
While investing in funds is generally considered liquid, not all funds offer high liquidity. There may be situations where redeeming your fund could disrupt your financial goals, making liquidation an impractical option. A loan against mutual funds can be a good choice for fulfilling your financial needs without sacrificing your investment goals or disrupting their continuity. 

Loan against mutual funds is a secured loan where borrowers pledge their mutual fund units as collateral to obtain a loan from banks or NBFCs. This provides a convenient short-term credit solution for addressing urgent financial needs without liquidating mutual fund investments. You can borrow a minimum of ₹25,000 and up to ₹5 crore against your mutual fund units. The processing fee for such loans typically ranges from 0.25 per cent to 1 per cent of the loan amount. Furthermore, the loan amount you can borrow is typically limited to up to 50 per cent of the net asset value of the mutual fund units pledged if they are equity funds. For Debt Funds, the limit is generally higher, ranging from 70 per cent to 80 per cent of the NAV. 

How Do LAMFs Work?
Let’s say you want to take a loan against mutual funds on an investment currently valued at ₹5 lakh. With a loan-to-value of 50 per cent, you would get a loan of ₹2.5 lakhs. It will function like an overdraft facility, similar to one available in a current account. Once the loan is approved by the lender, the overdraft facility gets activated, and you can withdraw the sanctioned amount. 

The most interesting feature that makes loans against mutual funds more favourable for the borrower than personal loans is that the borrower is not bound to withdraw all the approved amounts in one go. They can withdraw as per their needs, whereas in the case of a personal loan, the approved amount is disbursed into the bank account once the loan is approved. 

Furthermore, turning your attention towards the interest part, in the case of a personal loan, interest is charged on the disbursed amount from day one. On the other hand, in the case of LAMFs, interest is charged only on the amount withdrawn from the sanctioned limit. As per our example, your sanctioned amount was ₹2.5 lakhs but if the requirement is only for ₹1 lakh, the lender will charge interest only on the ₹1 lakh withdrawn and not on the whole amount. Moreover, the amount used can be paid at any time, such as in two days, five days, or held until the agreed loan tenure. 

Interest will be charged based on how the period for which the funds have been withdrawn. For example, if the amount is repaid within five days, the interest will be levied only for those five days and not for the entire month. You might wonder if there is any limitation on how many times a borrower can withdraw money. Generally, there is no limitation, but some banks or NBFCs may impose restrictions, which can be discussed while applying for the loan. 

Looking at the cost of the loan, on a loan of ₹50,000 for a period of 12 months at an annual interest rate of 10.5 per cent, the customer will pay monthly interest of ₹438 for 12 months. The total loan payment over 12 months will be ₹55,256 (including principal and interest). 

Total Cost of Loan = Interest Amount + Processing Fees + Stamp Duty = ₹5,250 + ₹999 + ₹500 = ₹6,749 Note: These charges can vary based on lender and the above computation is for illustration purposes only. 

Redemption Versus LAMFs
Generally, investors have two options: either liquidate or redeem your mutual funds to meet the financial requirements or take a loan against them. Keep in mind that building a strong portfolio with a substantial amount takes time— typically longer than 1-2 years. If you choose the first option, there are three important considerations. First, redeeming your funds won’t let you achieve your financial goals. Second, you will incur taxes on the redemption as mentioned below. 

The third important factor is the opportunity cost. Investing small amounts over time allows your mutual funds to benefit from market cycles and trends. By holding your investments longer, you can take advantage of rupee cost averaging and potentially earn better returns through compounding. On the other hand, if you take a loan, you avoid tax implications, fulfil your money requirements and remain invested and committed to your investment goals, allowing your money to grow. 

For example, we have calculated that the total cost of taking a loan was around ₹6,749 for a 12-month loan tenure (which includes the interest amount of ₹5,250, processing fees of ₹999, and stamp duty of ₹500) on a loan amount of ₹50,000. To repay it, you need to pay a total sum of ₹56,749 (₹50,000 + ₹6,749) at the end of the loan tenure. Let’s say during this 12-month period, your investment value has surged to ₹67,500 with an absolute return of 35 per cent. Even after paying the interest and charges, you would still be in profit, with a total profit of ₹10,751 with all your investments intact in your portfolio. 

The only situation where you need to worry is if the market experiences a correction, resulting in a decline in the value of the mutual fund on which you have taken a loan. So then, what if the market corrects and reduces the value of your mutual fund? Since mutual funds are market-linked instruments, they are subject to market risks. Let’s say the market falls and your mutual fund value drops to ₹4 lakhs from 5 lakhs, as per the earlier example. 

Due to this reduction in the value of your mutual, your LTV becomes 62.5 per cent which is above the threshold limit (50 per cent) and there is a need to restore it, else the bank might ask you to deposit an additional amount to cover the shortfall. In case of failure, the bank could charge you a penalty or charges for not restoring the LTV to the agreed levels or can sell a portion of your mutual fund holdings to recover the outstanding loan amount. 

Advantages of LAMFs
1. Liquidity without Liquidation: Taking a loan against mutual funds lets you access liquidity without selling your investments. By using your mutual fund units as collateral, you can meet short-term needs or emergencies while keeping your long-term investment goals intact.
2. Zero Foreclosure Charges: No lock-in and no foreclosure charges if you decide to repay your outstanding early. You can make payment towards your outstanding amount anytime with zero foreclosure charges. On the other hand, a bank will charge you while closing your personal loan account.
3. Attractive Interest Rate: Interest rate starting at 10.5 per cent per annum (on the utilised amount) with a flexible payment option which is generally higher in personal loans. Unlike term loans, interest on LAMF is levied only on the amount you use and for the number of days you utilise it.
4. CIBIL Score is not a Barrier: As it is a secured loan and the mutual fund units are kept as collateral for the lender, some banks may not ask for a CIBIL score and income status while applying for the loan, subject to their internal policy. 

Disadvantages of LAMFs
1. Limited Loan-to-Value Ratio: Lenders usually offer loans against mutual funds at a lower loan-to-value (LTV) ratio than the actual market value of your investments. This means you might not be able to borrow the full value of your mutual funds, limiting your access to funds. For example, you can typically borrow up to 50 per cent of the NAV for equity mutual funds and 70-80 per cent of the NAV for debt funds.
2. Limited Options: Not all banks offer loans against all mutual funds. For example, SBI only lends against its own mutual funds, while HDFC and ICICI Banks lend only against schemes managed by asset managers registered with CAMS. Axis Bank also has a specific list of mutual funds for which it provides loans.
3. Shorter Tenure: Generally, loans against mutual funds are for a shorter duration, typically 12 months. After that, the borrower needs to renew it, which incurs additional costs. According to Mirae Asset Financial Services, their annual renewal charge is around ₹999 plus taxes, which will eventually reduce the profits earned from the mutual funds.
4. Risk of Margin Calls: If your portfolio loses value due to market fluctuations, your lender may issue margin calls, requiring you to either repay part of the loan or pledge additional assets. Failing to meet these calls could lead to the liquidation of your mutual funds, resulting in potential losses. 

Conclusion
In summary, loans against mutual funds offer a viable option for meeting short-term financial needs without having to liquidate your investments, thereby preserving your long-term investment goals. They tend to be more cost-effective compared to personal loans and credit card loans, offering the flexibility to repay early without foreclosure charges and charging interest only on the withdrawn amount. 

However, there are some drawbacks to consider. LAMFs typically have shorter tenures, often requiring renewal after 12 months, which can incur additional costs. The loan-to-value ratio is usually lower than the actual market value of your investments, limiting the amount you can borrow. Additionally, not all banks offer loans against all mutual funds, and market fluctuations may lead to margin calls, requiring you to either repay part of the loan or pledge additional assets. 

LAMFs are especially advantageous when your portfolio yields a high annual return, such as between 12 per cent and 15 per cent, and you can secure a loan at a favourable interest rate, like 10.5 per cent. In such scenarios, opting for a LAMF is generally a preferable option. Nonetheless, it’s important to remember that once your mutual funds are pledged, you cannot exit or sell those holdings until the loan is repaid though you can continue with regular investments. 

However, if the market experiences a correction and your mutual fund value falls, it can trigger a margin call. This situation may require you to deposit additional funds to maintain the loan-to-value ratio. If you fail to do so, the lender has the right to sell your mutual funds to recover the outstanding loan amount. Overall, if you are facing a shortterm liquidity need and have a strong mutual fund portfolio, a loan against mutual funds can be an effective and efficient solution.