When you invest in mutual funds and after investing that money sometimes you have shortage of money. What would you do then? Probably you will try to redeem your mutual funds or stop your systematic investment plan. Instead of redeeming equity mutual funds you can think about borrowing money against your mutual fund units.
- We cannot borrow money directly from our mutual funds, but our mutual funds can be used as collateral for loans. Loans against mutual funds are called margin loans. Margin loans are usually obtained through stockbrokers, now days many banks are also in it.
- With a margin loan, we can borrow up to 50 percent of the value of our mutual funds. Though such loans against mutual funds should be used to buy more stocks or mutual funds, we can use it for other purposes.
- No need to sell mutual fund units
- Your financial plan remains unaffected.
- There are no tax implications.
- Our ownership of fund units after pledging them for a loan is also unaffected.
- Provides immediate liquidity against the mutual fund units that you own. It is like an overdraft facility for short-term monetary requirements, with a relatively shorter tenure than other loans.
- One of the main benefits of borrowing money against our mutual fund as opposed to borrowing against shares of an individual stock is that mutual funds are less volatile than individual stocks. We will be less likely to get a margin call when we borrow against our mutual funds because they are way more diversified
- The interest rates and sales commission can easily chew away any profit we make on selling our mutual funds.
- When the stock market takes a serious plunge and the value of your mutual fund drops too far down in price, we will get a margin call from our stockbroker or bank. A margin call is when the broker or bank needs us to deposit more cash into the account to cover our losses. If we don’t have the cash the broker or bank needs to bring our account balance back to an acceptable amount, the broker or bank will automatically sell some of our mutual fund shares to repay part of what we have borrowed.
Should You Borrow?
- Just because we can borrow money against our mutual funds doesn’t mean we should borrow.
- Taking a loan against mutual fund is good option when we know how to pick good mutual funds and we have a plan to use the money to buy more mutual funds.
- If we are new in world of investment or our plan is to use the borrowed money to buy a car, it isn’t the good idea. As we can lose investment capital we have worked hard to build.
How to apply?
Units in demat form
- Some online portals give us the opportunity to pre-approve a loan and keep even before we need one. This would work easily if we have mutual fund units in demat form.
Units in Physical form
- The process could be longer if we hold units in physical form, as we first need to execute a loan agreement with our financier (broker or a bank).
- Then the financier (broker or bank) will write to the mutual fund registrar and asks them to mark a lien on a certain number of units that we have pledged.
- Generally financier (broker or bank) lend about 60-70% of the value of our pledged units.
- After receiving such a letter the registrar marks the lien and he sends a letter to the financier (broker or bank) with a copy to us confirming the marking of a lien on the units.
- When we repay the loan borrowed, the financier (broker or bank) asks for removal of the lien, he sends a request letter to the fund house.
Interest rates for loan against mutual funds
- We can pledge our mutual fund units with a bank or a non-banking finance company to take a loan.
- The loan amount taken can be paid back at the interest rate agreed with the financier.
- Generally Interest rates on loans against your mutual funds will run you about 10.5 percent to 12 percent.
- When the units are under lien, we can’t sell or switch the units.
Default in repayment of the loan
- If we defaults in making payment, the financier has right to enforce the lien.
- He owns right to send a signed request to the fund house to redeem our units.