Is pledging shares and mutual funds better than taking a personal loan?

You are in immediate need of money. You have some investments in shares and mutual funds but don't want to redeem them now. You have checked with multiple avenues such as banks and fintech companies for a personal loan. The interest rate offered to you is very high. You wonder what other means could be to meet your cash requirement. The good part is, if you have shares and mutual funds but don't want to redeem them, there is an option for arranging emergency funds: Pledging. 

Pledging involves investors using their investment holdings, such as stocks, mutual funds, or other securities, as collateral to secure loans from financial institutions or lenders. The collateralized assets provide lenders with a level of security, reducing their risk in case the borrower defaults on the loan. Unlike selling securities to raise funds, pledging allows investors to retain ownership of their assets. This ensures they can benefit from any potential future appreciation in the value of those assets.

Pledging often results in lower interest rates compared to conventional personal loans or credit card debt. The collateral acts as security for the lender, reducing the risk and, consequently, the interest rate. For example, while personal loans are offered in the range of 12-20 per cent, you can pledge your mutual fund units at 9-12 per cent.

Krishna Kanhaiya, Chief Executive Officer, Mirae Asset Financial Services (India) Pvt. Ltd explains how pledging works and dos and dont’s of pledging

What is the procedure for pledging mutual fund units? 
Krishna Kanhaiya: In the case of the physical process that most of the players in the market follow, a pledge request form is submitted by the customer to the lender. The lender in turn submits it with the respective RTA (KFintech/ CAMS). The RTA creates the pledge and confirms it back to the customer as well as the lender. 

The entire process takes 2-3 days. We at Mirae Asset follow digital lien marking through APIs and the entire process is done in a couple of minutes. The customer inputs OTP on our mobile app/ website to get into the respective RTA’s system. The customer can see the holding and choose the schemes and number of units he/ she wants to pledge and calculate the eligibility. After selecting the schemes and number of units the customer inputs one more OTP and the pledge is done.

1) How much is the loan-to-value ratio? 
Krishna Kanhaiya: Loan to value ratio in the case of equity mutual funds is 45 per cent and in debt it is 80 per cent. For shares, LTV is 30 per cent to 45 per cent depending on the shares.

2) How much is the interest rate charged?
Krishna Kanhaiya: We charge 9 per cent p.a. interest on the utilised amount for the number of days the amount is utilised. For example, if someone creates a limit of Rs 1 lakh and utilises only Rs 50,000 and pays back the amount in 1 month, interest is charged only on Rs 50,000 for one month. Basically, 9 per cent p.a. interest is charged on the daily outstanding balance. 

3) Can one prepay? 

Krishna Kanhaiya: There is no EMI. The client can repay the amount anytime during the loan period which is one year. There is no prepayment penalty. The client can renew the loan after one year.

4) Can I pledge my mutual funds units for buying a house?

Krishna Kanhaiya: Yes, you can. There is no restriction.

5) What are the do's and don'ts? 

Krishna Kanhaiya: Ideally, the loan against mutual funds/ shares should be used if you have long-term investments and short-term to medium-term money requirements. If you are holding investments in mutual funds for the short term, you should refrain from taking a loan against mutual funds to meet your medium-term to long-term money needs.

6) Can I claim a tax deduction if I am self-employed? 

Krishna Kanhaiya: Yes, you can claim a tax deduction if you are a self-employed person provided you demonstrate to tax authorities that you have used the loan amount for the business. However, we suggest the clients take his/ her tax consultant’s opinion.