There has been a lot of hype around getting loans using equity or debt mutual fund units as collateral. Many readers have asked if this is a good idea. In this article, we discuss whether loans against MF units are necessary.
The basic idea is quite simple. You pledge your MF units (to the extent necessary), and the bank uses them as collateral to offer you either a normal loan or an overdraft facility at 9.5-12% interest rates (variable). That is, the bank will own those MF units until you pay back the loan. It is a short-term loan, typically up to 12 months and can be renewed.
We have looked at all the so-called “benefits” and are not impressed: (1) You don’t need to redeem the units, they continue to earn returns, the long term “long-term compounding” is intact, (2) the interest rates are lower than a personal loan (but higher than a loan against FD); (3) In an overdraft loan, the bank will charge interest only on the amount drawn if it is lower than the max withdrawal limit (which is market-linked*).
* If the bond/stock market tanks or if there is a credit event in your debt/hybrid fund, the overdraft limit will sharply reduce. The thumb rule is that the higher the NAV volatility, the higher the interest rate.
Assuming the emergency was bigger than your emergency fund, why would you borrow when you already have the money to pay for an emergency? Just redeem from your mutual fund (or any other asset) and pay!
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This argument about “not losing long term compounding benefits by avoiding redemptions” is just an industry spin. The mutual fund industry will do anything to ensure we invest as much as possible and never redeem. A loan against MF units is just another gimmick to retain AUM.
First, while mutual funds are capable of good growth, they do not “compound” in the traditional sense. See: Don’t get fooled: Mutual funds have no compounding benefit! They do not offer a return higher than or equal to the loan rate year after year. So, a mathematical comparison of loan vs redemption or loan interest rate vs MF return is meaningless. Your unredeemed units could soar in value or tank, leaving you with a loan and lesser wealth (if your overdraft limit drops, you will have to pay the difference, or the bank will partially redeem your units).
Second, these loans are for a few months or, at best, 1-2 years. Sure, redemptions will affect the growth of wealth, but fresh investments can easily make up for this after taking care of the emergency without a loan.
A loan against MF units may prevent a redemption, but your future investments will be affected because you will have to pay interest. That will affect the growth of wealth as well. They don’t tell you this because the MF industry is not confident about you returning. So, they would rather push an option when they retain the money already invested. Remember, investor returns are always notional until redeemed. AMC (and distributor) returns (expense ratio and trail commissions) are always real – hence the drive to retain AUM.
We recommend that investors keep it simple. Build yourself a substantial emergency fund. Don’t stop contributing to your emergency fund (monthly 5% of take-home pay if possible). If your emergency costs more, then tough luck; redeem some investments and handle it. Then, focus on increasing your future investments and compensate for the redemption. Don’t complicate your already tough life with a loan against MFs. Just because it is easy to get does not mean it is necessary.
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