Loan against mutual funds: What happens when returns fall?- Key Insights
If you hold mutual fund units, you have the option to secure a loan against them as an alternative to pursuing a personal loan. While resorting to loans should always be a measure of necessity, borrowing against mutual fund units becomes more sensible during urgent situations due to the comparatively lower interest rates when contrasted with personal loans.
Nonetheless, it’s crucial to acknowledge the risk associated with borrowing against mutual funds. Let’s elucidate this through an example. Imagine you pledge a portion of your mutual fund units to secure a loan from a non-banking financial company (NBFC) or a financial institution. The unit price is higher when you initiate the loan process, but as the loan progresses, the price experiences a substantial decline.
What could transpire in such a scenario?
Krishna Kanhaiya, the CEO of Mirae Asset Financial Services, highlights that when the value of mutual fund units experiences a significant decline, the borrower’s eligible overdraft limit also reduces. Furthermore, if the revised limit falls below the utilized amount, the account becomes overdue and necessitates regularization. Kanhaiya underscores, “If the value of the security drops considerably, in such an event the eligible limit of the overdraft account drops and if the revised eligible limit is less than the utilised amount then the account becomes overdue and needs to be regularised.”
Borrowers need to be cognizant of this risk before opting for a loan against mutual funds. Additionally, there are various other crucial considerations that borrowers should factor in. In an email exchange with FE Money, Kanhaiya shared some key points that borrowers should be aware of.
Let’s delve into these:
Loan Details: It’s vital for borrowers to be well-informed about the maximum and minimum loan amounts, eligibility criteria, loan tenure, Loan to Value (LTV), and more. These parameters directly influence the borrower, necessitating their careful consideration before selecting a lender for availing a loan against mutual funds.
Cost of Borrowing: Understanding all charges and aspects pertaining to the cost of borrowing is paramount. Borrowers often focus solely on interest rates, overlooking other charges like processing fees, prepayment charges, security de-pledging fees, penal interest rates, etc.
Repayment Schedule and Flexibility: Another critical aspect is comprehending the repayment terms. A flexible repayment structure alleviates the burden; for instance, with a loan against mutual funds, borrowers can repay the principal at any point during the loan tenure, only servicing the interest monthly. This flexibility accommodates irregular cash flows.
Approved List of Mutual Funds: Different lenders have varying approved lists of mutual funds against which they extend credit. Some may only approve CAMS-registered funds, while others might restrict their list to specific asset management companies (AMCs).
Impact of Changing Investment Value: Given market volatility, the underlying asset’s value could witness fluctuations. Borrowers should clearly grasp how these value shifts affect their loan and, in the case of a fully utilized account, how they can regularize it.
Application and Other Processes: Evaluating the ease of executing various tasks such as de-pledging mutual funds, updating contact information, altering bank accounts, topping up existing loans, etc., is important. Often, procuring a loan might be straightforward, but managing account-related activities could prove tedious. The decision to borrow against mutual funds should be approached with a thorough understanding of these nuances. While this method can offer financial leverage, borrowers must navigate these intricacies for a well-informed choice.