Loan Against Mutual Fund: Is it risky? Important factors to consider before borrowing

Mutual fund investments have recently gained immense popularity among investors. As mutual funds offer diversification of portfolios and provide comparatively higher returns as against traditional savings instruments, more investors prefer this investment option. However, not many know that mutual funds can be used as collateral to avail loans.

Though it seems to be a convenient solution to financial problems, but it may not be a wise decision. The positive side is a loan against mutual funds helps you to get access to funds where there is a need.  Before availing a loan against mutual funds, the borrowers should consider a few important factors to avoid financial uncertainties in future.

What is a loan against mutual funds?

When you get such a loan, you pledge a portion of the mutual fund units as collateral with the borrower. The firm then provides a loan based on the Net Asset Value (NAV) of your mutual fund units. The loan amount typically ranges from 50 per cent to 70 per cent of the NAV, depending on the fund type and the lender’s terms and conditions.

Why should one opt for such a loan?

●     Liquidity Without Selling: The investor can liquidate their investments without selling them. This provides flexibility in investment decisions and offers immediate access to funds.

●     Low Interest Rates: These loans mostly come with lower interest rates when compared to personal loans or credit cards.  As borrowing against mutual funds is a type of secured loan, the interest rate is comparatively lower.

●     No Credit Check: Lenders often don't conduct an extensive credit check as these loans are secured against your mutual fund units.

Why would a loan against mutual funds be risky?

On the other hand, getting a loan against mutual fund units could be risky due to the following reasons:

●     Market Volatility: Mutual funds are subject to market risks and if the value of the pledged units decreases significantly then you might have to pledge more units as collateral or prepay a portion of the loan in order to maintain the loan-to-value (LTV) ratio.

●     Loss of Returns: There are high chances of losing returns as the units promised as collateral still continue to generate returns that can't be acquired by the borrower of the loan.

●     Default Risk: In case the borrower fails to repay the loan amount, the lending institution can sell the mutual fund units to recover the loan amount. Thus, the borrower will lose his mutual fund possessions and potential returns.

●     Several Charges: The borrower might have to pay for numerous charges, such as processing fees, valuation charges and other costs associated with these loans, which eventually lower returns.

Therefore, getting a loan against mutual fund units can be beneficial only if utilised judiciously.