Should you go for loan against mutual funds?

Recently, a cousin of mine called up late one night to ask – “My mom needed a sudden surgery. She doesn’t have insurance and the medical bill is likely to run to Rs 30 lakh. Should I take a loan against my mutual funds to pay the bill?” 

This surprised me because I knew for certain that she had at least Rs 40 lakh invested in mutual funds. Why not simply redeem them to raise the cash? 

“My mutual funds have been doing very well and I don’t want to interrupt the returns, you know. They are part of my retirement savings and I will be retiring in 10 years’ time”, she said. 

The fintech lender who had partnered with the hospital had pitched this loan option to her as a hassle-free way to settle her bills without her having to ‘disturb’ her MF investments. 

This episode alerted me to the fact that loans against mutual funds are now very popular, with folks using them for all kinds of purposes, from dealing with emergencies to punting on F&O (futures and options). 

Should you go for loan against mutual funds?

How loan against mutual funds work

Indian banks and NBFCs have been offering loans against securities for a long time now. The eligible securities were traditionally insurance policies, fixed deposits, shares and investments in small savings schemes. In recent years, mutual fund units have been included. 

A host of banks and NBFCs offers loans against mutual fund units online, on the following terms. 

  • Amounts ranging from Rs 25000 to Rs 5 crore. 
  • Interest rates of 9.99% to 12%, usually cheaper than personal loans because they are backed by collateral
  • Processing fees of 0.5% to 5%  
  • Tenures from 7 days to 36 months 
  • After a digital KYC, loans are extended quickly against the pledge of units online. 
  • Each lender has an approved list of mutual fund schemes against which you can take loans. Usually, the funds should be registered with CAMS, K Fintech or in a demat account. You can individually select the schemes you would like to pledge. 
  • Margins for loans against debt funds range between 10% and 25%. Margins for loans against equity and hybrid funds are at 50-60%. 
  • These loans work like overdrafts or revolving credit. On pledging your units, the lender opens an account much like an overdraft account. You can withdraw any part of the loan amount and will pay interest only on the amount withdrawn. 
  • Lenders allow prepayment of these loans if you have excess funds. But some levy prepayment charges going up to 5% of the outstanding amount. 
  • Penalties for delayed repayment range from 24%-36% per annum.  

Why loan against mutual funds is a bad idea

Most people seem to be drawn to loans against MFs because they are so easy to take. They probably see pledging MF holdings as more painless than pledging jewellery or an insurance policy. Your bank or MF distributor may also advise you against selling your MFs because thy stand to make a commission based on the assets you hold.  

But in most situations, redeeming your MF holdings is far better for you, financially, than taking a loan against them. Here’s why. 

Many people think that pledging their MF holdings instead of selling them, will leave their wealth ‘undisturbed’ as they’ve worked so hard to build it. This is flawed logic. 

It doesn’t consider that the loan will make an even bigger hole in your net worth than selling your investments. When you take a loan of say Rs 30 lakh from a lending entity at a 12% annual interest for 36 months, you end up paying the lender Rs 40.8 lakh to close out the loan. 

To understand this, all you need to do is to visualise your personal net worth as your assets minus liabilities. A loan expands your liabilities and thus reduces your net worth by Rs 40.8 lakh.

This is without taking into account the other hidden costs of taking a loan, such as processing charges, account maintenance charges and prepayment charges that add another 4-5% to the loan value.  

Therefore, your net worth takes a hit of over Rs 41 lakh though you actually need only Rs 30 lakh. Now, many people believe that their MF investments can easily make up that extra Rs 11 lakh if they just pledge and hang on to their equity funds. Based on the past 10-year CAGRs of 12-13% pa from equity funds, they think a 11% or 12% return over the next 2-3 years is manageable. 

But this ignores the fact that equity funds do not deliver returns in a linear or predictable fashion. They will have some negative years, some years of single digit returns and some positive years, which lift up their CAGR in the long run. It would be quite unrealistic to assume that equity funds will appreciate at say 11% or 12% per annum over short periods such as 2 or 3 years to cover your loan costs, especially when a bull market has been on for a while.  

Many folks are loath to redeem their MFs, especially equity funds, because they see good returns on their portfolios today. They are loath to ‘interrupt’ these returns to meet unplanned expenses. 

This is why financial planners recommend having a separate emergency fund apart from your goal-based portfolios. The very purpose of parking emergency money in MFs is to redeem them when needed.

But this apart, the returns that you see today on your equity MF portfolio are essentially past returns. As MFs are market-linked products, there’s no guarantee that past performance will be repeated in future. 

Selling your equity funds today may look like the wrong decision because you think that they will continue to deliver a 13% or 14% CAGR. What would you say if the stock markets were to correct sharply next month? Foregoing future returns which are uncertain in any case, is better than paying interest to a lender. 

More importantly, redeeming your current MF holdings does not stop you from making further investments to benefit from future returns on the same funds. 

If you are worried about missing out on future returns, the best thing to do will be to set up SIPs immediately after a redeeming your MFs, to rebuild your MF wealth. 

If that Rs 30 lakh loan against equity MFs entailed an EMI of Rs 30,000 a month, you can invest the EMI amount in equity SIPs. If the stock markets continue to deliver a 13% CAGR, a Rs 30,000 SIP will get you to Rs 30 lakh in just 5 years’ time. 

If markets crash, you can pat yourself on the back on cashing out at right time, and anyway use SIPs to rebuild your corpus at lower market levels. So you win either way. Similar logic will work for redeeming from debt funds too.

When you pledge your MF holdings with a lender, you do not get a loan for the entire value of holdings pledged. Based on their margin rules, lenders extend loans only for a part of the value pledged.  

Most lenders levy a margin of 50% on equity MF holdings and 25% on debt MF holdings.  Therefore, to take a Rs 30 lakh loan against equity MFs, you’d have to pledge Rs 60 lakh of your MF portfolio. Should your emergency needs extend beyond Rs 30 lakh, you cannot withdraw from the remaining Rs 30 lakh MF holdings even if you have them as the lender has a lien on them. For debt MFs, you will need to pledge Rs 45 lakh worth of units to get your hands on Rs 30 lakh. 

When you pledge your MF units, they will continue to earn returns. But then, you will be deprived of liquidity to meet other expenses, which is one of the biggest benefits of investing in MFs as opposed to other assets. 

Pledging your gold jewellery or insurance policy to get a loan makes slightly more sense, because these are illiquid assets. Try as you might, you cannot liquidate your jewellery at current market prices of gold and get instant cash for it. You will take big haircuts towards making charges, wastage etc. Ditto with insurance policies where premature surrender can mean bearing surrender costs. 

But MFs are liquid investments, where you get to exit at zero extra cost at the prevailing NAV (you need to pay capital gains tax of course).  Pledging them to get a loan after sacrificing a margin of 25% or 50% makes little sense.

Most folks borrowing through the MF route seem to be assuming that markets can head only one way – Up. But with stock markets enjoying a stellar run in the last few years, the probability of a correction has risen. Should the value of your MF holdings fall soon after you take a loan, you risk getting a margin call from the lender. 

In the above example, suppose my cousin took a Rs 30 lakh loan against her equity MFs worth Rs 60 lakh and the stock market corrects by 15% this month. The lender would then approach her to cough up another Rs 9 lakh to fulfil the margin requirement of 50%. This is because the correction would have reduced the value of the pledge to Rs 51 lakh. If she can’t put up the additional margin, she may need to repay the loan to the extent of Rs 4.5 lakh. 

While margin calls are more likely with equity or hybrid funds than debt funds, they can sometimes play out in debt too, if a sharp spike in interest rates leads to mark-to-market losses. 

How to redeem your mutual funds

One reason people cite for taking a loan against MF units instead of selling them, is the incidence of capital gains tax

It is true that capital gains tax will take a bite out of your redemption proceeds when selling your MF units. 

While you cannot avoid this tax, you can reduce tax incidence by planning your redemptions carefully.  

  • When selling equity funds, you can choose to sell funds which you have held for 12 months or more, to reduce the tax incidence from short term capital gains tax (15%) to long term capital gains tax (10%). 
  • You can try and spread equity fund redemptions over two financials years instead of one, if you are close to the financial year end). This can help you save upto Rs 2 lakh from capital gain tax. Long term capital gains (LTCG) on equity funds are exempt from tax to the extent of Rs 1 lakh a year. 
  • You can apply the same strategy to older debt fund holdings too. On debt funds bought before March 31 2023, LTCG rates of 20% with indexation apply, if you held them for 36 months or more. Slab rates apply if you held them for shorter periods. On debt funds bought after March 31 2023, however, there’s no scope for tax planning as capital gains are taxed uniformly at your slab rate. 
  • Selling 3 year plus holdings can help with hybrid funds too. Lower rates of 20% LTCG with indexation can be availed in the case of hybrid funds whose debt exposure is less than 65%. 
  • If you own some loss-making funds, you can sell them to set off the loss against capital gains on your profitable funds. 

Finally, you can also minimise the dent to your long-term wealth (arising from redeeming prematurely) by selling over-valued assets and retaining under-valued assets. 

Today, stock markets in India are fairly expensive after a good rally over the last 5 years. Bond markets on the other hand are just recovering from a bear market caused by rising rates post-Covid. 

If you need money for an emergency, it would not be a bad idea to redeem equity-oriented funds today, ahead of debt-oriented ones. 

So, is there any situation in which taking a loan against MFs could be better than redeeming them? I can think of just one. If you need a large sum of money for a very short period such as a week or a month, then redeeming your MF holdings and paying capital gains tax only to reinvest the entire money a little later, will not make sense. 

In this case, a loan against MFs could make sense because the interest (plus processing and prepayment charges) you pay could work out to be lower than the taxes you pay on selling your MFs. But you need to make this comparison for yourself before taking the loan. 

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23 thoughts on “Should you go for loan against mutual funds?”

  1. Loan against mutual fund makes more sense if you are 200% sure that there will be a cashflow from source other mutual funds to fully pay off the loan. Also the loan duration should not be more than 1 month.

  2. Ganesan Rajagopal

    I think loan against mutual funds is a good idea in many circumstances. Aarati pointed out one such situation when you’re borrowing for a short time like a week or a month. But given that the loan is an overdraft, it makes sense even for longer duration as long as you can prepay the loan as soon as you can. I have done in the past and having a ready overdraft upto 50% of your funds or shares can be a great alternative or an additional buffer to your emergency fund.

    By redeeming mutual funds you’re not only paying capital gains tax, you also lose time in the market. I disagree a SIP can make up for it, that’s essentially betting that you can time the market (i.e current valuations are too high and SIP would get better returns). I would rather borrow against MFs, pause any SIPs and repay as fast as possible.

    Also the lock-in is not really a big deal, if you do want to exit the funds held in lien, most of the lenders will facilitate this quite easily. If you’re financially disciplined, loan against shares/mutual funds, or even better a home saver kind of loan can be very handy for quick access to funds.

  3. Preferably Anonymous

    Good analysis! I took a short 3-month LAMF because I needed funds the same day for which MF redemption takes time. It was quick and easy through Mirae Asset Securities or something (not the AMC, maybe a sister concern) and they charged only 9% interest at the time. They would send DAILY email/sms which got annoying. So I blocked all their emails/sms and then I forgot about this loan. It is auto debit so no missed payments but I would have closed it within a week instead of the 3 months if I hadn’t forgot about it.

  4. Very good article. In your view, do these points also hold true when deciding on taking a home loan v/s selling MF investments to fund the house purchase?

    1. Thank you. I am a conservative investor so would always liquidate investments if I could take a smaller loan. But in a home loan, the tax break reduces your interest outgo. So if your MFs can outperform that, a loan can work out better. But uncertainties related to equities will remain.

      1. one of the other advantage of selling MF investments to buy a home (if its your first or second house) you get entire capital gains waived off (sec 54F)… so instead of loan, selling MF makes sense… the equivalent home loan EMI can be ploughed back into MF every month.

  5. There is another case where loan aginst MF may be a better option eg slump in market after covid like situation? But one cannot be 100% sure that market has bottemed out.

  6. sirsa.chandraa

    I am an MFD and I share a similar opinion.

    If my clients need money, I simply ask them to redeem their MFs.

    I ask them to imagine that they are borrowing from their own portfolio @12% rate of interest and ask them to pay EMI in the form of future SIPs to their own portfolio.

    1. Preferably Anonymous

      Kudos to you! That is a great idea! Unfortunately, most MFDs are not like you and get a bad rap for being commission hungry at the cost of investors.

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