Loan Against Mutual Funds

There are times in life when you just have to take loans- for a medical emergency, a marriage or a much-needed holiday. You would most likely avail a personal loan which charges high interest and struggle with EMI repayments. This is exactly what happened to Shankar, a 28 year old man, who took a personal loan to go on a holiday.

Shankar a young man had dreams. He lived in the southern part of India, in a town in Kerala. He was a teacher at a nearby school with a take home salary of Rs 20,000 a month and he wanted more from life. He badly wanted to holiday in the North East. So he availed a personal loan of Rs 2 Lakhs from his bank with a tenure of 3 years at an interest rate of 16% a year.

For those who don’t know, a personal loan is a No Reason Loan. Banks don’t ask reasons for availing the loan.  There’s no collateral. The problem is banks charge interest of 14-21% a year on a personal loan. You might not be able to afford the EMIs and fall in a loan trap.

This is exactly what happened to Shankar. After an enjoyable holiday, it was time to think of the personal loan EMIs. He had to pay nearly Rs 7,100 a month for the next 3 years. This didn’t seem a problem till a medical emergency ate up his savings. Shankar struggled with personal loan EMIs and today is in deep debt.

Ideally, one should not take a loan for your wants.  You could take it for your needs.  We suggest you invest towards your vacation and then take your vacation.  However, if you cannot avoid taking a loan, taking a loan using your mutual funds as security, is one option. Use an overdraft facility in your bank account. This will help if you need is only temporary.  There’s no need to redeem mutual fund units and you can continue with SIPs. During a financial emergency, don’t liquidate mutual funds. Just avail a loan against mutual funds.

You can avail a loan against equity mutual funds, debt funds or hybrid mutual funds by approaching a bank or an NBFC and pledging mutual fund units as collateral. The loan is sanctioned based on the Net Asset Value, NAV of the mutual fund units in the folio and the loan tenure. You get loan against mutual funds at an interest rate of just 10-11% a year and as its secured, interest rates are much lower than the commonly availed personal loan. If you have a good credit score and have been a customer at the bank for a really long time, negotiate for a lower interest rate.

If the mutual fund units are in demat form, several online portals are willing to sanction loans within minutes. If the units are in physical form, you might need a loan agreement with the bank. You have to understand lien on mutual funds before we go further. It’s a document that gives the bank the right to sell the mutual fund units. This comes in handy for the bank if you’re not able to repay the loan. The lien grants the bank ownership of the mutual fund units you own. Approach your mutual fund house and request for a lien on mutual fund units in the name of the bank for a lien transfer to the bank.

How to get loan against mutual funds? Simply log on to your internet banking account and select the equity or debt funds you want to hypothecate. Your application is redirected by banks to CAMS or Karvy which verify the mutual fund holdings. The registrar marks a lien against mutual fund units being pledged with a letter send to the bank and a copy marked to you to confirm the lien. The lien is marked against the mutual fund units, so this means you cannot redeem units, until the loan is repaid. You continue to enjoy dividends and other ownership benefits, but you can’t redeem the pledged units. Equity based funds can fetch a loan as high as 50% of the NAV, while for debt funds its 60-70%. Banks allow you to avail a maximum of Rs 20 Lakhs against equity mutual funds.

Don’t make the mistake of not repaying; or the bank will ask the mutual fund to redeem units and take the money. Banks have a list of mutual fund units against which they lend.

Shankar availed a personal loan at an interest of 16%; while you get a loan for just 11% against mutual funds. This is a sizeable savings in interest. Shankar should have invested in mutual funds via SIPs and then gone on holiday. Loan against mutual funds are great when stock markets fall. If you need money in a hurry, just pledge mutual fund units, instead of redeeming them at a loss.

Mutual Funds Better Than FD?

Mahesh is 31 years and works as a lecturer in a top private college. He is well paid and earns Rs 13 Lakhs a year. Mahesh has always invested in FDs and the reason is simple. FDs are safe and offer decent interest. Mahesh stays far away from mutual funds as he believes they invest in stocks making them extremely risky. Is Mahesh Right? Do mutual funds only invest in stocks?

When you say mutual fund, the first thing that come to mind is the equity mutual fund. Mutual funds are not all about stocks. They do invest in fixed income instruments. Let’s take a close look at fixed maturity plans also called FMPs, a type of mutual fund and how they are better than fixed deposits.

FMPs are closed-ended debt funds with a fixed maturity period normally just over 3 years to take advantage of the long term taxation. You can invest in FMPs through a New Fund Offer or NFO. Closed-ended means the FMP has an opening date and a closing date and you must invest within this time. FMPs invest your money in money market instruments like certificates of deposits, commercial paper, corporate bonds, treasury bills among others. They invest in debt instruments and you can check the credit rating before investing.

Mahesh doesn’t like risk in investment. Mahesh asks only this question? Are FMPs safe like FDs? In FDs you already know the maturity value of the invested amount at the time of investment itself, as interest rate is fixed. FMPs offer only indicative yields, but the Yield to Maturity of the portfolio is disclosed regularly. FMPs also invest in safe debt products.  Infact, some of them invest into PSU and Bank deposits/bonds only. You can also choose an FMP with a high credit rating.  Though the NAV is reported daily and may vary in line with movements in interest rates, if you hold to maturity, the returns are largely fixed.

If you want higher returns than FDs and are willing to bear a slightly higher risk, then invest in FMPs. FMPs are low risk investments compared to equity mutual funds. FMPs are listed on the stock exchange, but liquidity may not be available at all times on the exchange and hence are less liquid than FDs.

Mutual Funds vs FDs

When it comes to taxes, FMPs score over FDs, especially if you fall in the highest tax slab. The interest earned in FDs is added to taxable salary and you are taxed as per your tax bracket. Mahesh falls in the 30% tax bracket and FD interest income is taxed at the highest rate or marginal rate of tax.

In FMPs, taxation depends on the type of fund. Choosing the dividend option means you bear the dividend distribution tax, DDT of 28.84%, which is slightly lesser than the marginal rate of tax on FDs. It’s in the growth option of FMPs where tax is saved.

If you quit the FMP before 36 months, gains called short term capital gains are added to taxable income and taxed asper tax bracket. If you stay invested for 3 years or more, gains are called long term capital gains which attract 20% tax with the indexation benefit. Indexation inflates the purchase price of the FMP, saving tax.

If Mahesh invests Rs 10 Lakhs in FDs of 3 year tenure, the interest earned is taxed at the highest tax rate of 30%. If the FD offers 7% interest, this translates to a post-tax yield of 5%, which isn’t much. Lets say Mahesh invests Rs 10 Lakhs in an FMP of same tenure. FMPs can give returns of around 7.25-7.5% a year, though returns aren’t guaranteed. With the indexation benefit, post tax returns are nearly 1.25-1.75% higher than FDs. This makes FMPs a better investment than FDs on a post tax return basis.

Will Mahesh invest in FMPs over FDs for higher returns?  Investing in FDs largely erode your wealth if you consider impact of taxes and inflation. (ie. if you are in the higher tax brackets.)  FMPs are quite safe, especially if you chose a fund that invests in quality debt. FMPs are a smarter option, and may just help you beat inflation on a post tax basis.  That’s a call that Mahesh can take if liquidity is not a requirement for him.