When to sell your MF and when to borrow against it

What should you do if you need money urgently but your funds are tied up in mutual funds that you have accumulated diligently over the years?

Selling the mutual fund (MF) units is convenient as you can get the money in a day or two. However, it can derail your investment momentum and put your life goals at risk. What if you can get the funds without selling your MF units?

Yes, a loan against MF units is a very convenient option nowadays to get quick access to some money. However, this loan comes at a cost and may not always be advantageous for the borrower.

We tell you why you need to be careful before opting for this easily available funding option.

How to decide whether to redeem MF units or take loan on them

The first thing you must consider is the nature of your funding requirement. “For short-term requirements, typically between three months and a year, opting for a loan against mutual funds is more advantageous. This option allows you to access funds quickly while your investment continues to earn returns,” says Aryaman Vir, CEO of WiseX.

The flexibility offered by such a loan may work well for you even if you are not sure how long it will take for you to repay the loan.

“The overdraft facility in a loan against mutual funds plays a crucial role here. It provides a flexible credit line against your mutual fund holdings, offering immediate liquidity without liquidating your investments. You only pay interest on the amount utilised, not the entire credit limit, making it a cost-effective solution for short-term financial needs. This way, you can meet your urgent financial obligations while keeping your long-term investment strategy on track,” says Vir.

When going for loan against mutual fund gives you a better deal

All mutual fund schemes are not similar. They vary significantly on risk and returns parameters. Therefore, a one-size-fits-all approach will not work while taking a call on loan vis-a-vis redemption.

You need to decide on the basis of the categories of mutual fund schemes you are invested in. The fundamental factors that should guide you is the differential of return that you can potentially earn on your MF investment and what you need to pay on your loan.

Should you take loan when you have equity mutual fund?

Equity mutual funds have the potential to deliver high returns in the long run. Breaking such investments to meet short- and medium-term funding requirements should be avoided as much as possible. “When it comes to equity mutual funds, choosing a loan against securities is often more beneficial than liquidating your investment. This is particularly true if you expect the value of these funds to increase over time. By opting for a loan, you maintain your investment, allowing it to grow, while simultaneously accessing the necessary funds. This approach helps avoid losing out on future gains that could occur if you were to sell in a rising market,” says Vir.

However, you need to make sure that the cost of the loan is on the lower side.

What should you do in case of hybrid mutual fund?

A good number of hybrid funds have significant levels of equity exposure and, hence, they are expected to deliver better returns than debt funds in the medium to long run. “Hybrid funds, which include exposure to equity, are typically aimed at longer-term growth through the compounding effect. Selling units of hybrid mutual funds, especially during a bull market, may mean missing out on potential long-term compounding benefits and the higher returns that equity exposure can offer,” says Vir.

Therefore, selling an investment that has significant equity exposure before reaching your goal should be avoided as far as possible. “For hybrid mutual funds, it’s generally better to remain invested to capitalise on the compounding effect and the potential higher returns from the equity component, rather than selling the units prematurely. The decision should be aligned with the specific characteristics of the fund type and your financial objectives,” says Vir.

When you should rather sell the holding than going for a loan

When the cost of borrowing using MFs is much higher than the expected return on your investment, it is better to sell the units rather than using them to take a loan. This usually happens in case of debt funds. “If the interest rate on a loan against your debt mutual funds is lower than the expected returns from these funds, opting for a loan can be financially sensible. This way, you benefit from the continued returns while addressing your immediate cash needs,” says Vir.

Consider exit load and tax impact before deciding on redeeming your MF units

Many mutual funds usually charge an exit load for redeeming investments before 1 year. Check if your MF scheme also has this charge before deciding to sell the units. Another critical factor that you must consider before selling your MF units is the tax implications.

“Redemption triggers capital gains tax, either short term or long term, and possibly an exit load, reducing your net earnings. In contrast, a loan against mutual funds does not incur capital gains tax as the investment is not sold. This approach allows the funds to potentially grow while avoiding immediate tax liabilities,” says Vir.

How a loan against MF works

A loan against MF usually comes in the form of an overdraft. “Assets in the form of mutual funds can serve as collateral, and the availability of both term loans and overdraft loans depends on the lender. Many lenders — modern fintech companies and traditional banks and NBFCs — provide overdraft loans against mutual funds,” says Rohit Pateria, Co-founder, Lark Finserv.

The tenure of the loan in case of an overdraft is usually 12 months, after which the loan has to be renewed by paying renewal charges. Some lenders may offer the advance as a term loan and for shorter tenures. “Borrowers have the flexibility to repay these loans over 3, 6 or 12 months, and there are no foreclosure charges for early repayment,” says Pateria.

The loan limits will vary depending on the lender. While Mirae Asset Financial Service (MAFS) offers a loan that is as low as Rs 10,000, the minimum loan amount offered by HDFC Bank is Rs 1 lakh. Most prominent banks give up to Rs 20 lakh as loan against equity MFs; however, SBI and ICICI Bank offer up to Rs 5 crore for loans on debt MFs. MAFS, on the other hand, offers Rs 1 crore as loan against equity MFs and Rs 3 crore in case of debt MFs.

In the case of equity mutual funds, you can typically get up to 50% of your fund value as a loan; it can go up to 80-85% in case of debt funds or FMPs. “Mutual funds have loan-to-value (LTV) ratios of up to 60% for equity, 70% for hybrid, and 80% for debt funds. The LTV is determined by the underwriting model employed by the lender,” says Pateria.

The interest rate that you get is usually higher for equity MFs and typically in the range of 9.3%-11% in the large banks.

Loan against mutual fund units under loan against securities

Lender HDFC Bank ICICI Bank State Bank of India Mirae Asset Financial Service
Nature of credit Overdraft Overdraft Overdraft Overdraft
Minimum Loan Amount Rs 1 lakh Rs 50,000 Rs 25,000 Rs 10,000
Maximum Loan Amount Rs 20 lakh Rs 20 lakh /Rs 5 crore ** Rs 20 lakh /Rs 5 crore ** Rs 1 crore / Rs 3 crore
Interest Rate 10.60% / 9.31%# 10.80% / 10.30%^ 11.05% 9%-24%
Max Loan to Value, Equity MF 50% 50% 50% 45%
Max Loan to Value, Debt/FMP MF 80% 80% 85% 80%
Processing Fee Rs 1,499 / Rs 3,500 * plus GST Rs 500 plus GST 0.50%, Min: Rs 1,000 Max: Rs 10,000 plus GST Rs 999 + GST
Renewal Charges Upto 0.50%, Min Rs 1,000, max Rs 5,000 plus GST Rs 2,500 plus GST Rs 1,000 + applicable GST Rs 999 + taxes as applicable

Note: *Digital/Physical, **Equity/Debt MF, #Average IRR for Equity/Debt MF during July’23 to Sept’23, ^Equity/Debt MF

Source: Websites of the respective lenders

How the pledging of MF units work

Borrowers have to pledge their MF units to get a loan against MF. This makes it a secured loan. The process is done by lien marking, which can now be done digitally. “Clients are presented with the option to pledge specific mutual fund schemes and choose the desired value for loan collateralisation. This customisation allows them to tailor the loan amount according to their needs. The lien marking process, crucial for both physical and demat schemes of mutual funds, is facilitated through OTP-based verification,” says Pateria.

As the value of the MF keeps fluctuating, the lien marking may also go through changes. If you have pledged only a part of your MF holding, you can redeem the rest if the need arises. “The lien mark can be revoked in case of loan repayment. Partial lien marking can also be revoked in case of partial repayment or in case the MF NAV goes up substantially,” adds Pateria.

William Murphy

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