In the world of personal finance, having liquidity without disrupting your investments is a big win. And that’s exactly what a Loan Against Mutual Funds (LAMF) offers.
In this blog, we’ll go beyond the basics to explore who provides LAMF, how the process works in detail, effective interest rate, how it compares to Gold and personal loans and when it’s better to take LAMF.
By the end, you’ll have a deeper understanding of whether taking a loan against mutual funds is the right move for you.
Estimated read time: 7 minutes and 13 seconds
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Buckle up. Here we go!
What is a Loan Against Mutual Funds (LAMF)?
A LAMF is a secured loan where you pledge your mutual fund units to borrow money, mostly as an overdraft (OD) facility.
The lender marks a lien (or claim) on your mutual fund units, which means you can’t sell or redeem them while they are pledged. However, you continue to benefit from any potential capital appreciation or dividend payouts during this period.
One of the key advantages of LAMF is that the interest rates are generally lower than unsecured personal loans. But beyond that, LAMF offers flexibility, allowing you to borrow funds without disturbing your long-term investment strategy.
It’s essentially a way to monetise your investments or assets temporarily without fully liquidating them.
How does it benefit you?
- You continue to stay invested in the market.
- Your mutual fund units keep generating returns.
- You only pay interest on the amount you utilise, because of the OD facility.
The maximum loan amount depends on the value of the mutual fund units and the lender’s margin requirements. As per RBI regulation, the maximum loan-to-value (LTV) ratio of equity mutual funds is 50%, and that of debt mutual funds is 80%.
Who Provides Loans Against Mutual Funds?
Several institutions offer loans against mutual funds, each with its own terms and conditions. Here’s a quick look:
- Banks: Many leading banks in India, like HDFC, ICICI, and SBI, offer LAMF.
- Non-Banking Financial Companies (NBFCs): NBFCs like Bajaj Finserv, Mirae Asset and Tata Capital are also active in providing LAMF.
- Brokers: Some stockbrokers like Zerodha and ICICI Direct allow you to pledge your mutual fund holdings in the Demat Account.
- FinTech Startups: Startups such as Smallcase, Volt and Yenmo have begun offering LAMF.
Remember, that most institutions provide loans against mutual funds based on the Statement of Accounts (SOA) format. They typically do not provide loans on mutual fund units held in a Demat account because it’s more challenging to mark a lien on them.
How Does a Loan Against Mutual Funds Work?
Taking a loan against mutual funds might seem simple on the surface, but there’s a detailed process behind it. Here’s a deeper look at each stage:
1. Application and Eligibility:
- You apply through your bank, NBFC, broker, or FinTech platform. Typically, online platforms offer a streamlined, fully digital process, while banks might require additional documentation like income proof.
- The lender checks your portfolio for eligible funds. Not all mutual funds can be pledged, particularly sectoral or thematic funds, as they are highly volatile.
2. Lien Marking:
- Once the loan is sanctioned, a lien is marked on your mutual fund units, meaning the lender now has a claim on them. You can’t sell or redeem these units until the lien is lifted (i.e., the loan is fully repaid).
3. Loan Sanctioning:
- The loan amount is typically a percentage of the market value of your mutual funds. For equity mutual funds, it is around 50% of the current NAV, while for debt mutual funds, it is around 80%.
- In most cases, the loan will be issued through an OD facility. The loan duration is 12 months, you can renew the OD facility at the end of each year.
4. Margin Calls:
- If the value of your mutual fund holdings drops significantly (because of market volatility), the lender may issue a margin call. You’ll be asked to either top up the collateral by pledging more units or partially repay the loan.
- If you ignore the margin call and the value continues to drop, the lender may sell your mutual fund units to recover their money.
5. Repayment and Lien Removal:
- You can repay the loan in part or in full. Once the loan is cleared, the lien on your mutual fund units is removed, and you regain full control of your investments.
How Does Margin Call Work in LAMF?
In a LAMF, a margin call is a critical mechanism designed to protect the lender when the value of your pledged mutual fund units falls below a certain threshold. Here’s how it works:
1. Initial Lien and Loan-to-Value Ratio (LTV):
When you take a LAMF, the lender assigns an LTV ratio to your pledged mutual fund units. For instance, if the LTV is 50%, and your mutual fund portfolio is worth ₹10 lakhs, you can borrow up to ₹5 lakhs.
2. Market Fluctuations:
Mutual funds, especially equity funds, are subject to market fluctuations. If the Net Asset Value (NAV) of your mutual fund units drops, the overall value of your pledged collateral decreases. This change affects the LTV ratio.
Let’s say you took a loan of ₹5 lakhs with an LTV ratio of 50%, and your mutual fund portfolio was originally valued at ₹10 lakhs. If the market drops and the value of your mutual funds declines to ₹8 lakhs, the LTV now exceeds the 50% limit.
New LTV Ratio: ₹5 lakhs (loan) / ₹8 lakhs (new fund value) = 62.5%.
This LTV exceeds the agreed-upon 50%. Now the lender will issue a margin call.
3. The Margin Call:
A margin call is a formal request from the lender to restore the LTV ratio to the required level. The lender typically gives you a few options:
- Provide more collateral: You can pledge additional mutual fund units to bring the LTV back within the acceptable range.
- Partial loan repayment: You can make a partial repayment of the loan to reduce the outstanding balance and bring the LTV ratio back in line.
- Do nothing: If you fail to respond to the margin call, the lender reserves the right to sell your pledged mutual fund units to recover the shortfall.
4. Risk of Forced Liquidation:
Any shortfall in maintaining the LTV ratio because of market movements in asset prices must be corrected within 7 working days (Notice day plus 6 days) if the LTV goes up to 60%. On the same day (On the notice day by 7 PM), if the LTV goes above 60%.
If you don’t meet the margin call within the stipulated time, the lender can sell part or all of your pledged mutual funds to recover the loan amount. This could be a significant disadvantage, especially if the markets are down, as your units might be sold at a low NAV, leading to losses on your investments.
5. Managing Margin Calls:
- Monitor your investments: If you’ve pledged equity-heavy funds, which are volatile, regularly monitor their performance. Keep track of market conditions and anticipate possible declines that could trigger margin calls.
- Maintain a buffer: It’s wise not to max out the LTV ratio. By borrowing a smaller percentage of your mutual fund value (e.g., 40-45%), you create a buffer against market drops.
- Have backup collateral or cash: In case of a market downturn, be prepared to either pledge more units or make a partial repayment to avoid forced liquidation.
A margin call in LAMF is essentially a safeguard for the lender but a risk for you as a borrower, particularly in volatile markets.
However, if you manage the loan prudently, margin calls can be avoided by maintaining a conservative borrowing ratio and monitoring market trends.
Effective Interest Rate on Loans Against Mutual Funds
While the interest rate on LAMF is generally lower than unsecured personal loans, you must consider the total cost of the loan to understand the true financial impact.
- Interest Rate: LAMF interest rates typically range from 9% to 12% per annum, depending on the lender, the type of mutual fund, and the loan amount. This is usually lower than personal loans but may be slightly higher than secured loans like gold loans.
- Processing Fees: Lenders may charge a processing fee, usually ranging from 0.25% to 2% of the loan amount. Some banks or FinTech platforms may waive off this fee for smaller loans or promotional purposes.
- Other Charges: If the mutual fund units are held in Demat form, there could be additional DP charges for pledging the units, which is a minor but necessary expense. Institutions also charge renewal fees and penalty fees.
The effective interest rate, considering all these factors, can range between 10% to 14%. Make sure to ask for a breakdown of all fees to understand the full cost of the loan.
How Does LAMF Compare to Other Loans?
1. Gold Loan vs. LAMF:
- Interest Rates: Gold loans generally have lower interest rates (8-11%) compared to LAMF. This is because gold is considered more stable than mutual funds.
- Loan Amount: Gold loans can offer a higher LTV ratio, up to 75-90% of the gold’s value, compared to 50% for equity mutual funds.
- Risk Factor: Gold is far less volatile than mutual funds, meaning the risk of margin calls is negligible.
2. Personal Loan vs. LAMF:
- Interest Rates: Personal loans have higher interest rates (typically 12-24%) because of their unsecured nature.
- Collateral: With no need for collateral, personal loans are easier to secure in theory but come with stricter eligibility criteria and longer processing times.
- Risk: Since personal loans don’t require any collateral, you won’t risk losing assets, but the high interest rates can make them costly.
When Should You Take a Loan Against Mutual Funds?
Best scenarios for LAMF:
- Short-term liquidity needs: LAMF is ideal for short-term financial needs, especially when you’re confident about repaying within a few months.
- Retaining investments during market uptrends: If your mutual funds are performing well and you don’t want to miss out on future gains, LAMF allows you to maintain your portfolio.
- Lower cost than unsecured loans: For someone who requires a quick loan and has a sizable mutual fund portfolio, LAMF is cheaper than a personal loan.
When to avoid LAMF:
- During high market volatility: If markets are highly volatile, there’s a greater risk of margin calls and potential losses if your pledged funds are sold.
- Long-term needs: LAMF is not suited for long-term financing. The ongoing interest payments and potential margin calls make it a poor choice for long-term borrowing.
- No Loan Against Debt Mutual Funds: It is better to avoid taking loans against the debt funds because the returns from debt funds are lower than loan interest rates. Better to sell your debt funds to cover your emergency requirements.
Final Thoughts
A loan against mutual funds can be a smart way to unlock liquidity without disrupting your investments, especially if you need funds quickly and expect the market to perform well.
However, it’s essential to carefully consider the effective interest rate, the possibility of margin calls, and how it compares to other loan options before making a decision.
For many investors, LAMF can serve as a middle path between redeeming mutual fund units and taking a personal loan, offering both flexibility and financial prudence.
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Still Curious?
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
ET Money – Loan Against Mutual Funds – A Complete Guide | How to Apply | Eligibility | Interest Rate
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.
