“Hey Varad! I urgently need money. How much time will it take for the funds to reflect in my bank account if I sell off my mutual funds?” My phone buzzed with this notification.
I knew this message required more than a direct reply on WhatsApp. So, I instantly called back the client to understand her needs. The client had a decent amount saved in her mutual funds accumulated over the years. She wanted to sell off her holdings to fund a course she wanted to do to upgrade her professional skills.
I had to talk to her to help her understand that there was a better alternative than liquidating her mutual fund holdings. I made her understand about loans against securities, a smarter way to access liquidity.
The conversation we had about loans against securities is important not only for my client but for many of us. So, let us explore how loans against securities (LAS) can be a better alternative to redeeming your mutual funds in most scenarios.
What is a Loan Against Securities?
In simple words, a loan against securities is the loan you can avail of by pledging your investments as collateral.
The investments that can be pledged as collateral include mutual funds, stocks, bonds, government securities, or fixed deposits. The most important point here is that you still hold the ownership of your investments while getting access to the fund you need.
Things You Must Know About Loan Against Securities
Interest Rate in loans against securities
When you take a loan against your securities, you will obviously have to pay interest. But, LAS usually comes with lower interest rates compared to personal loans and credit card loans. The interest rate typically hovers between 10%-11%, which varies from lender to lender.
Loan Amount (LTV – Loan to Value)
A very important question pertaining to a loan against security is how much you can actually borrow against your security or investment. The amount you can borrow depends on the value of the securities you pledge.
Equity mutual funds and stocks generally have an LTV ratio of 50%-55%, while debt mutual funds and government securities may go up to 60%-65% of their market value.
Let’s understand this with an example.
Scenario 1:
You have an investment of 10 lakhs in an equity mutual fund. And, let’s say the offered Loan-To-Value is 50%.
You can borrow 5 lakhs, pledging your investment of 10 lakhs in this case.
Scenario 2:
You have an investment of 10 lakhs in a debt mutual fund. And let’s assume the offered Loan-To-Value here is 65%.
You can borrow 6.5 lakhs, pledging your investment in this case.
Repayment Options in LAS
Another important consideration while opting for a loan is repayment, right? A loan against securities is considered helpful as it offers flexibility in repayment.
To manage your cash flow, you can opt for interest-only payments for a set period and then repay the principal later. Many lenders even allow prepayment of the loan without any charges.
Interest Payment Frequency
Lenders offer flexibility in how frequently interest is paid, depending on the type of loan facility:
- Monthly (default): Most LAS accounts are set up to require monthly interest payments.
- Quarterly (on request): Some lenders may allow interest payments every three months, if requested.
- Daily (for overdraft facility): If you’re using an overdraft-based LAS, interest is calculated and debited daily, only on the drawn amount, making it a cost-efficient option for short-term or fluctuating needs.
Loan Tenure
LAS is generally structured for short to medium-term funding. Most lenders offer LAS for a tenure of up to 12 months, which can be renewed if required. But, there are longer tenure options too.
Some lenders offer extended loan tenure up to 2 or 3 years. This is typically allowed when the collateral or pledged security includes stable, long-term debt securities or large portfolios.
Margin Calls and Risk
One of the risks associated with loans against securities is the possibility of margin calls.
If the value of the pledged securities falls significantly, the lender may ask you to provide additional collateral or repay part of the loan. However, this can be avoided by staying updated on market conditions and maintaining a sufficient margin. This is where you may need a trusted supporting hand to guide you.
Availing a Loan Against Securities vs. Redeeming Mutual Funds
You now know what a loan against securities is. But, it is also important to understand the key differences between availing a loan against securities and redeeming your mutual funds. Without understanding both, it will be a little difficult to make an informed decision when you need funds.
Ownership
The first difference between the two options is that you retain the ownership of your fund when you take a loan against it. On the other hand, redemption of a mutual fund means you lose your ownership.
Compounding Effect
Your fund keeps growing even when you have taken a loan against it. At the same time, you lose the chance to grow your fund when you redeem it, as the investment gets withdrawn.
Interest Rate
When you take a loan against your securities, you will obviously have to pay interest. But, LAS usually comes with lower interest rates compared to personal loans and credit card loans. The interest rate typically hovers between 10%-11%, which varies from lender to lender.
Taxation
When you take a loan against your securities, you don’t get any additional tax burden due to a margin call. However, redemption of a mutual fund attracts capital gains tax. The exact tax burden will be based on the number of years for which the investment was held and the type of investment.
Liquidity and Access to Funds
The pledging and approval process for a loan against securities is quick, and typically, the amount reflects in your bank within 48 hours. And this happens without disturbing your investment. In case of redemption, you get immediate access to your funds.
Margin Call Risk
If the market falls significantly, a loan against securities attracts the margin call risk. In case of mutual fund redemption, there’s no risk of margin calls.
Use Cases
If your funding need is short-term term the best bet is to take a loan against securities and repay the loan as soon as you can. But, if you have a long-term need or want to do loss booking then redeeming your mutual funds may be the wise decision.
Why Should You Consider a Loan Against Securities?
Now you understand the differences between redeeming your mutual fund investments and taking a loan against them. But still, you might not be very clear as to why taking a loan and paying interest thereon is a better choice. So, let me tell you the most compelling reasons for you to consider a loan against securities.
To Retain Your Long-Term Investment Goals
When you start investing, you start with long-term goals. You should not allow something temporary to derail your financial goals. The biggest advantage of taking a loan against securities is that you can maintain your investment. This means the compounding effect continues, allowing your investments to grow over time.
By avoiding redemption, you keep your investments intact and your long-term financial goals on track.
To Access Funds at Lower Interest and Opportunity Cost
When compared to selling off your investment, taking a loan against security is a better option, as the redemption of the investment comes with opportunity cost. Once you redeem your investment, you lose the chance to grow your fund.
On the other hand, when you compare a loan against security with other loan options like a personal loan and credit card loan, it comes with a cheaper interest rate. The interest on loan against securities is typically around 10% – 11%. Whereas, personal loans come with an interest rate of 12% – 18% and a credit card loan can have an interest rate as high as 36%.
To Avail a Flexible Repayment Option
By choosing loans against securities, you choose ease because they come with flexible repayment structures. You can choose to pay just the interest periodically, and the principal can be repaid later. Some lenders even offer no foreclosure charges and allow prepayments without penalties.
This flexibility can be a game-changer, especially if you need time to plan your repayment strategy.
To Avoid Unnecessary Tax Burden
Unlike mutual fund redemption, which can trigger capital gains tax, a loan against securities does not involve selling your assets. The loan itself is not taxed unless your securities are sold due to a margin call, which occurs only when the market falls significantly.
This makes a loan against securities a more tax-efficient way of accessing funds compared to liquidating your investments.
My Take
Most of the financial emergencies can be taken care of when you know your options and plan prudently. As a professional dealing with such situations almost on a daily basis, I can say the most important thing you need in case of financial emergencies is a calm mind that can think reasonably.
Taking loans against securities is one of the options that you can opt for rather than panic-selling your investments and ruining your pace towards your future financial goals. If you understand your funding needs, repayment capabilities, and market conditions, you are well-equipped to pick the right option in case of sudden fund needs. And, if you ever feel you need someone more experienced to hold your hand during such challenges, Team MoneyAnna is just a click away.
