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Coronavirus lockdown: Cash crunch? Don't sell your mutual funds, take a loan against it!

Coronavirus lockdown: Cash crunch? Don't sell your mutual funds, take a loan against it!

When you approach a lender for loan against mutual fund, it fixes a loan-to-value (LTV) ratio against it. It varies from one lender to another as per risk involved in the MF scheme and regulatory caps fixed by the RBI

One of the key benefits of loan against securities is it comes cheaper compared to other personal loans One of the key benefits of loan against securities is it comes cheaper compared to other personal loans

KEY HIGHLIGHTS

  • Loan against mutual funds is easily available from banks and NBFCs
  • Loan amount is typically around 50 per cent of your equity fund value
  • Debt or hybrid MF holding may enable you get higher loan amount
  • Credit limit works like an overdraft; interest rate charged only on withdrawn limit
  • Interest rate depends on your credit score; typically in the range of 9-12%
  • Credit limit increases when market rises, decreases when market falls
  • Avoid availing entire limit for margin of safety

If you invest in mutual funds and are facing cash crunch amid coronavirus-led lockdown, you may feel redeeming your mutual fund units will meet your funding requirement. However, you have a better option to make use of your MF units. Not many know that you can take loan against your mutual funds. Not only will it come at a lower interest rate than that on personal loans, it will let you stay invested in the market. With the recent crash in the market, redeeming your units at lower NAVs will hardly do any good. If you rather take loan against it, it will meet your immediate funding needs and you would still stand a chance to earn higher returns whenever the market recovery happens. Read on to know all about loan against MFs:

How does it work

When you approach a lender for loan against mutual fund, it fixes a loan-to-value (LTV) ratio against it. It varies from one lender to another as per risk involved in the MF scheme and regulatory caps fixed by the RBI. For example, the RBI has capped the LTV ratio at 75 per cent of the NAV in case of equity and hybrid funds, while there is no cap on debt funds and non-convertible bonds.

"Lenders set upto 60 per cent as the LTV ratio for equity mutual funds, up to 50 per cent for equity shares, up to 70 per cent for non-convertible bonds and up to 85 per cent for debt mutual funds. As the risk assessment of lenders can vary for each security, the LTV ratio offered for each stock or mutual fund scheme can vary across various lenders," says Sahil Arora - Director & Head of Investments, Paisabazaar.com.

Once the holdings get pledged to a lender, it will create a lien on the security and a Loan Against Securities (LAS) account is opened in the name of the borrower. You won't be able to sell your pledged units. However, you can continue your SIPs into the same MF scheme.

How withdrawal and repayment work?

The loan amount that you receive is offered in the form of overdraft. You can keep withdrawing and repaying within the sanctioned limit till the time you avail the overdraft facility. The interest is calculated only on the drawn amount until it is repaid and not on the overall credit limit.

However, you must know that the credit limit that you receive is market-linked. It rises if the stock market performs well and decreases during market downturn. If the withdrawal limit slips below the amount that you have already withdrawn, the lender will ask you to make good the difference either by paying upfront or by pledging more securities.  "Failing to do so can attract penal charges on the excess drawn amount," says Arora of Paisabazaar.

Costs involved

One of the key benefits of loan against securities is it comes cheaper compared to other personal loans. "Since the loan is backed by an asset, the interest rates are lower than that of a personal loan and are typically in the range of 10-12 per cent," Choudhary of Goalwise.com informs.

However, you need to be mindful of costs involved in it. First, Lenders may require the borrower to service the interest component incurred every month. Second, There can be a one-time processing charge, annual maintenance charge for the LAS account and some other miscellaneous fees which may vary from bank to bank.

The interest rate depends on your credit score as well. "If the credit history is good, then the institution might charge an interest rate of 9 per cent but if the credit history is poor, then probably a bit higher," says Rachit Chawla, CEO, Finway

Not all MFs eligible for loans

Note that not all mutual fund schemes get eligible for loans. Each lender bank or NBFC will have a list of approved mutual funds and stocks against which they will be willing to give loans.

"Lenders set the list of 'approved securities' primarily on the basis of the risk assessment of the individual securities. As the risk assessment  regarding each security varies across lenders, the lists of 'approved securities' for loan against mutual funds, shares and debentures too are different for various lenders. Note that the RBI has also barred lenders from lending against close-ended mutual funds and those in lock-in periods," says Choudhary of Goalwise.com

When to take it, when to avoid

If you know your funding crunch will only last for the short-term, it is better to make use of loan facility so that your mutual fund remains invested to participate in recovery and earn dividends while pledged units will help you deal with urgent requirement for money.  

"Being an overdraft facility, loan against share or mutual funds can be an effective instrument for meeting frequent short-term cash flow mismatches. Those having investments tied up for long-term financial goals can use this credit facility to mitigate their immediate financial emergencies," says Arora of Paisabazaar.

However, it should not be used for long-term loans. "In that case it might be better to just liquidate the underlying asset instead of paying a high interest rate on it," says Choudhary of Goalwise.com.

Further, you should resort to loan against MFs only in case of emergency. "One should resort to it only in a situation where they are certain that the money lying under MFs or stock will give them better yield than the rate of interest applicable. Equity market is volatile and risky, yet more often than not, it generates far better returns than any other asset class".

Besides, be careful when you borrow against MFs during market downturn. Whatever withdrawal limit has been allotted to you, make sure you don't exhaust it fully so that some margin of safety remains and you don't have to repay the loan prematurely or pledge more units in case the value of your units decreases. In case of big crash there remains the risk of liquidation of investment. In extreme cases, lenders may choose to liquidate your investments to recover the loan value, cautions Ankur Choudhary, Co-Founder and Chief Investment Officer -Goalwise.com.

In the bullish market, however, you should refrain from taking loan against MFs. it will be better to redeem MF units to meet your funding requirement instead of paying interest on the loan amount.

Also read: BT Insight: 8 money lessons from coronavirus lockdown

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Published on: May 09, 2020, 1:26 PM IST
Posted by: mansi jaiswal, May 09, 2020, 1:26 PM IST