A financial crisis, small or big, can occur at any time. It often happens that investors require money in a short period. Even if not all mutual funds offer high liquidity, you can use them as security to avail loans from banks.
Among other options, you may consider borrowing against mutual fund units as a natural alternative. The advantage here is you don’t have to redeem your units prematurely. This also ensures that your Systematic Investment Plan (SIP) can continue without a hitch. The process is similar to the overdraft facility that bank accounts offer. You can avail loan against equity or hybrid mutual funds by approaching any non-banking financial company (NBFC) or bank. For the bank to consider your loan request, you need to pledge your mutual fund units as security for the debt. The loan will be given based on the value of units in the folio and the tenure you choose.
You can repay the loan at an interest rate of 10% to 11% on the mutual fund units. Of course, this will be subject to the terms and conditions set by the financier and loan tenure. Since it is a secured loan, the interest rate will be lower than that of an unsecured loan. Also, if your credit score is good or you have been a longstanding bank customer, then the bank manager might agree for a lower interest rate.
Before we proceed further with the process to avail this loan, it is essential to understand lien on mutual funds. Lien is a document that gives the bank the right to sell the fund or hold it. Hence, if you mark a claim in the name of the bank, then you grant the bank ownership of the fund units you own.
You then need to approach fund house and ask for a lien on your units in the name of the bank. All the unit holders must sign the request letter for lien transfer.
Many online portals sanction loans quickly if you hold units in the Demat form and have prior permission. In case you physically own fund, then a loan agreement with the financier/bank should be in place.The lender asks mutual fund registrar like CAMS or Karvy to mark a lien on the number of units being pledged. The registrar then marks the lien and sends a letter to the lender with a copy to the borrower confirming the lien. An important thing to keep in mind is that the lien is marked against the units and not the amount. You cannot redeem the units before you completely repay the loan.
It is important to note that the amount of money that you can get as a loan depends on the type of mutual fund you own. For instance, equity-based funds can fetch you close to 50% of the Net Asset Value of your funds. Some banks also have a maximum and minimum cap on the loan amount that you can apply for.
Once the loan is repaid, the financier can send a request to the fund house to lift the lien. You can also enforce a partial removal of lien in case the financiers receive part payment, and this will free up some units while the rest would still be under claim. The bank can reinforce the lien if the borrower fails to repay the loan in the duration agreed upon. Same goes for defaulting too. In such a situation, the lender requests the mutual fund to redeem the units and send the cheque to the lender.
Loans against mutual funds are quite a rare practice due to lack of awareness and information on the subject. So next time you think of alternative ways of raising a contingency fund, remember that a loan against your mutual funds can be a better option than traditional instruments.