Loans against mutual funds may come at a lower interest rate, but experts urge caution

Loans against mutual funds may come at a lower interest rate, but experts urge caution
  • Loans against mutual funds come at an interest rate of 8-10% which is lower than high-cost unsecured loans
  • If the market corrects and your portfolio value falls, your loan eligibility might decrease and you may need to pay off the difference
  • Experts advise redeeming the MF units and putting the EMI you would have otherwise paid as an SIP in the same fund

When in need of money, especially at short notice, a personal finance loan is one option. However, being an unsecured loan, personal loans come with high rates of interest. But if you own mutual funds, you can get a loan against mutual funds at a lower rate of interest. However, there are a few things one should consider.

The concept of loan against mutual funds operates by leveraging your mutual fund portfolio. For instance, if you hold a portfolio valued at approximately ₹1 crore, you have the option to obtain a short or long-term loan of around ₹50-80 lakhs against it. These loans typically have a duration of one year but can be renewed annually.

“For equity portfolios, you can typically secure a loan of up to 45% to 50% of the portfolio's value, which translates to around ₹45 lakhs to ₹50 lakhs. In the case of debt portfolios, the loan amount can be as high as 80% of the portfolio's value, equating to around ₹80 lakhs,” says Soumya Sarkar, Co-founder, Wealth Redefine, a mutual fund distributor.

What works for loan against mutual funds

The first advantage of such a loan is that it will come at an interest rate of 8-10% which will be much lower than interest rates against personal loans which can be as high as 14-24%.

Another primary benefit of obtaining a loan against your mutual fund lies in the fact that you can access funds without having to liquidate your portfolio. If you are bullish about your portfolio, you may feel reluctant to redeem your mutual fund units. By opting for a loan against your mutual fund, you can sidestep these drawbacks.

Furthermore, there could be a numerical advantage to leveraging this strategy. For instance, if your portfolio is experiencing a 15% growth rate and you secure a loan at 10%, you effectively save 5 % by leveraging your assets. However, this is the case only when the markets are performing well.

What happens when the markets correct sharply?

If there is a sharp market correction, there are evident risks with this strategy. For instance, consider having a portfolio worth ₹1 crore with equity and having taken a loan of ₹45 lakhs. If the portfolio value drops to ₹80 lakhs due to the correction, your eligibility reduces to around ₹30 to ₹35 lakhs. Therefore, it's crucial to constantly assess whether the portfolio is fully leveraged or not.

For instance, if the portfolio value drops to ₹80 lakhs, your eligibility decreases from 45 lakhs to 35 lakhs. If you've already taken a 45 lakh loan and your current eligibility is ₹35 lakhs, ideally, you should bridge this gap and pay off the difference of ₹10 lakhs. If not, you risk undue liquidation of your portfolio in a bear market.

“The financial institution may deduct units from your mutual fund holdings to cover this amount, although they may not explicitly disclose this process. If you fail to pay continuously for 3 to 6 months, they may redeem a portion of your mutual fund units to settle the outstanding loan balance,” says Sarkar.

What should you keep in mind?

However, B. Srinivasan, director and founder of Shree Sidvin Investment Advisors, says that he does not allow his clients to take loans against mutual funds. “Loan means that the interest is a fixed cost. And you cannot pit fixed cost against variable return,” he says.

At the time of taking the loan, the markets may be doing well and one may feel confident that one will make more money than the interest rate. If the markets are correct, as they did recently, they may sell their units at lower costs and incur losses.

“Those who have a lot of clarity and can accept losses can apply for such a loan. What I would suggest is that when one needs money they redeem the units and put the EMI they would have otherwise paid as an SIP in the same fund. Because when you do not borrow, you are not answerable to anyone,” says Srinivasan.

So, while a loan against mutual funds may be a better option when you need money compared to a personal loan, you should be aware of the pitfalls before you opt for such a loan.