6 Things to Know about Loan against a Mutual Fund
In times of financial need, the conventional approach is to sell off assets, but there's an alternative that doesn't require unwinding your investments: leveraging your Mutual Fund.
By securing a Loan against Mutual Funds from a financial institution or an NBFC, you're essentially tapping into the worth of your investments while retaining them. This arrangement provides a twofold advantage: your investment portfolio remains intact, potentially accruing further earnings, and you gain the necessary funds to address your immediate financial requirements. This article aims to demystify the process, benefits, and considerations of taking out a Loan against your Mutual Fund investments, making it understandable even for novices in the financial world.
What is a Loan against Mutual Fund?
A loan against a mutual fund is a credit facility extended by financial institutions to individuals or businesses using their mutual fund investments as collateral.
This type of loan allows investors to meet their liquidity needs without having to sell their investments, potentially avoiding capital gains taxes or missing out on future appreciation. The amount of the loan typically depends on the value of the mutual fund units pledged, with different funds (equity, debt, hybrid) being assessed differently due to their inherent risk profiles.
Loans against Mutual Funds offer flexibility and quick access to funds, making them an attractive option for covering unexpected expenses or capitalizing on new investment opportunities.
However, it's important to note that if the market value of the pledged Mutual Funds falls below a certain level, the borrower may need to provide additional collateral or repay part of the loan to maintain the loan-to-value ratio. This mechanism ensures that the loan remains adequately secured throughout its tenure, aligning the interests of both the borrower and the lender.
6 Things to Know about Loan against Mutual Fund
1. Avail Loans to Only a Certain Limit of Your Mutual Fund Holding
When considering a Loan against Mutual Funds, it's essential to understand that lenders only allow you to borrow a percentage of your holding's value. This limitation is based on the loan-to-value (LTV) ratio, which varies depending on the type of mutual fund and the lender's policies.
This risk mitigation strategy protects the lender by ensuring the loan is backed by a buffer in case of market fluctuations that might affect the fund's value.
Typically, you can expect to receive around 50-70% of the value of your Equity Mutual Funds as a loan, while Debt Mutual Funds might offer a higher LTV, sometimes up to 80-85%.
2. Not All Banks Offer Loan against Mutual Funds
Not all banks offer Loans against Mutual Funds because assessing the value and risk associated with these assets requires specific expertise and systems.
Unlike more straightforward collateral like real estate, mutual funds' value can fluctuate significantly, requiring banks to have real-time monitoring systems. Additionally, the process of lien marking and the redemption process in case of a default adds complexity. Therefore, only banks with the necessary infrastructure and risk appetite tend to provide this service.
3. Mutual Fund Loans are Less Expensive than Credit Cards and Personal Loans
Loan taken against Mutual Funds typically come with lower interest rates than those associated with credit cards or personal loans.
This difference in cost is rooted in the nature of the loan's security. With Mutual Funds as collateral, the lender's risk is minimized because if the borrower fails to repay, the lender has the right to redeem the mutual fund units to recover their funds.
On the other hand, credit cards and unsecured personal loans do not have such collateral, presenting a higher risk to lenders, who in turn charge higher interest rates to mitigate this risk.
As a result, for an investor with Mutual Funds, choosing a loan against their investment can be a more cost-efficient borrowing strategy.
Generally, the interest rates on loans secured by Mutual Funds fall between 9% to 12%, notably lower than the rates for personal loans or credit card debt, which can escalate to 15% to 20% or more.
4. On Your Pledged Mutual Funds, You Will Still Receive Returns
Even when Mutual Funds are pledged as collateral for a loan, the ownership of these investments remains with the borrower, meaning any dividends or capital gains continue to accrue to the investor's account.
The act of pledging simply grants the lender a right to sell these assets if the borrower defaults on the loan. Until such an event, or unless the terms specify otherwise, the borrower retains all the benefits of ownership, including the potential for investment returns.
5. Efficiency in Processing and Accessibility of Funds
The advantage of obtaining a Loan against Mutual Funds lies in its efficient processing and rapid access to funds.The efficiency stems from the liquidity and the ease of determining the value of Mutual Funds, which can be quickly appraised to establish the loan amount due to their market-linked nature.
Advancements in digital technology within the banking and investment sectors have led to sophisticated integrated systems. These systems offer real-time valuation of funds and streamline the lien marking process, which secures the lender's interest in the collateral until the loan is fully repaid. Such speed in processing is particularly valuable when immediate access to funds is crucial, positioning this type of loan as a dependable resource in urgent financial situations.
To obtain a loan secured by mutual fund holdings, applicants need to provide essential documentation as a part of the application procedure. The required documentation generally encompasses:
- A government-issued ID to establish your identity.
- Proof of residence to confirm your living address.
- Verification of employment as evidence of your revenue stream.
- Legal documents verifying your ownership of the Mutual Funds in question.
6. Understanding Margin Calls and Associated Risks with Loan Defaults
A margin call is a significant risk when taking out a Loan against Securities. It occurs when the value of your Securities value [including Mutual Funds] falls below a certain level, prompting the lender to protect their loaned amount.
Essentially, the loan is granted against the mutual fund units, which act as a guarantee. Market volatility can erode the value of these funds, leading to a situation where the collateral no longer covers the agreed percentage of the loan, known as the Loan to Value (LTV) ratio.
If the market value of the Mutual Funds pledged as collateral decreases, the LTV ratio increases beyond the lender's acceptable threshold. To rectify this imbalance, the lender issues a margin call, which is a demand to restore the LTV ratio to its initial level. You, as the borrower, are then faced with two choices:
- Deposit additional collateral: You can opt to pledge more mutual fund units or other acceptable forms of collateral to increase the security behind the loan, thereby lowering the LTV ratio back to a safe level. This option hinges on having additional assets at your disposal to pledge.
- Sell part of the investment: Alternatively, you can sell a portion of your Mutual Funds to raise cash. This cash is then used to pay down part of the loan, effectively reducing the outstanding amount and bringing the LTV ratio back into balance. However, this means liquidating your investments, which could have tax implications and may also disrupt your long-term investment strategy.
Understanding Lien for Mutual Funds
A lien on Mutual Funds functions as a safety mechanism for lenders, ensuring they have a claim over your assets in case of default. It's akin to an official bookmark placed on your mutual fund units, flagging them for the lender's security while a loan is outstanding.
When a lien is marked, it doesn't alter the ownership of your mutual fund units; you remain the investor, and your funds continue to earn returns. However, it restricts you from selling or encashing those particular units, as they are now pledged against the loan.
How is Lien Marked?
Marking a lien in the context of Mutual Funds is a precise process, facilitated by technology to ensure legal enforceability and transparency.
When you secure a Loan against Mutual Funds, the lender interacts with the mutual fund's registrar, like CAMS or KFintech. These entities are responsible for maintaining the official records of mutual fund transactions and holdings.
Here's what happens in the lien marking process through a digital platform like Finsire:
- Loan initiation: Upon deciding to lend you money against your Mutual Funds, the lender starts the lien marking process.
- Registrar notification: The lender electronically notifies the mutual fund's registrar, detailing which specific units should be marked and the amount of the loan against them.
- Lien marking: The registrar then places a lien on the specified units, effectively freezing them for transactions other than for the lender's purposes.
- Integration with systems: This lien status is updated across several systems, such as Loan Management Systems (LMS), which track the repayment of loans, and Loan Origination Systems (LOS), which manage the processing of loan applications. The update ensures that all stakeholders, including you, the borrower, have real-time access to the status of the mutual fund units.
Using Finsire's infrastructure, lien marking, and portal integration is simplified to a process manageable by just a few clicks, offering a convenient solution for lenders. This integration allows lenders to connect their systems with Finsire's, enabling borrowers to initiate the lien-marking process themselves, which adds efficiency to the loan application workflow.
Furthermore, the ability to invoke or revoke liens is fully automated within Finsire's platform, streamlining these critical functions for the lender. This automation not only saves time but also reduces the potential for manual errors, ensuring that the status of assets is accurately reflected and managed throughout the loan's lifecycle.
Finsire's API offerings for Loan against Mutual Funds by CAMS, KFintech, and MFCentral
Benefits of Taking a Loan against a Mutual Fund
Securing an Overdraft against Mutual Funds offers multiple advantages, and among these benefits, Loan against Mutual Funds provide:
Lower interest rate: One of the primary benefits of taking a loan against a mutual fund is the lower interest rate compared to unsecured loans. Since the mutual fund units act as collateral, the risk for the lender decreases, which typically results in more favorable interest rates for the borrower.
You don't have to liquidate a mutual fund: Opting for a Loan on Mutual Funds allows you to retain your investments, thus preserving the potential for capital growth and income. You avoid the need to sell your assets, which can be especially advantageous if selling would incur high taxes or if the market is down.
Quick money: A loan against MF is often processed faster than other loans, particularly because the Mutual Funds already exist as assets, making it a straightforward collateral to assess and process. This makes it an ideal option for those in need of immediate funds.
Short-term capital needs: If you have short-term financial needs, an Overdraft against Mutual Funds can be an excellent way to address them without disrupting your long-term investment strategy. You can meet your current requirements while keeping your investment plan on track.
Pay interest for the used loan amount: Unlike traditional loans, where interest is paid on the total borrowed amount, Loan against Mutual Funds can be structured as an overdraft facility. Here, you only pay interest on the amount of the overdraft that you actually use, which can lead to significant cost savings.
Wrapping Up
The digital era has streamlined financial processes, making it easier to secure finances through Loan against Mutual Funds. This option not only grants quick access to funds without the rigors of traditional loan applications but also allows your mutual fund investments to flourish, potentially increasing in value. LAMF stands out as a smart financial strategy for those looking to leverage their investments while maintaining a solid investment foundation for the future.
Frequently Asked Questions
Is it good to take a Loan against Mutual Funds?
Taking a Loan against Mutual Funds can be advantageous if you need liquidity without selling your investments, which might be appreciating in value or entail exit costs. It typically offers lower interest rates than unsecured loans, making it a cost-effective option.
What are the restrictions on mutual fund borrowing?
Borrowing against mutual funds often comes with restrictions like a maximum loan-to-value ratio, eligibility criteria based on fund type and performance, and sometimes specific end-use stipulations set by the lender.
How do I repay a Loan against Mutual Funds?
A Loan against Mutual Funds is typically repaid through an EMI (Equated Monthly Installment) structure or as an overdraft where interest is paid only on the amount utilized, with the principal repaid either in lump-sum or as agreed with the lender.
