Should You Avail of a Loan against Mutual Fund to Sail through COVID-19 Crisis?

Jul 27, 2020


The COVID-19 pandemic has brought with not just global health emergency, but also unprecedented financial uncertainties. Millions of working-class citizens are facing financial crisis of some sort owing to layoffs or salary cuts.

To deal with the financial crunch people either turn to banks for a personal loan or dip into their investments. Many people are using high-interest debt such as personal loan and/or credit card to deal with financial crisis and to meet expenses such as rent, utility bills, etc.

However, in my opinion, while these measures can provide liquidity in the short term, over the long term it can prove to be perilous for your personal finance. Being saddled with debt is the last thing you would want when dealing with a financial crisis.

It would not be prudent to take personal loans as the interest rate can be as high as 25% per annum or more depending on the bank/financial institute. One must also ensure not to go overboard while using credit cards. In case of late payment of bill, credit card companies charge a high annual interest rate of around 35%-45%.

Failing to make timely payments attracts a penalty and affects your credit score. This can have adverse impact on one's finances.

On the other hand, liquidating your investment should be avoided as it can act as hurdle on your journey to achieving your future financial goals. Besides, redeeming investments are subject to taxes and exit loads/penalties. Ideally, investments should be redeemed only if you have achieved your financial goals or to save your investment from irrecoverable losses.

In such scenario, loan against mutual funds can be a cheaper alternative without denting a hole on your investments.

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What is loan against mutual fund?

Mutual fund investors can avail of a loan against their mutual fund investment. Various banks and financial institutes offer loan against equity, debt, hybrid funds as well as exchange traded funds. Loans can also be availed against ELSS, Retirement Plan, and Children Plan that come with a lock-in period, provided that funds have completed the required lock-in period. The loan can be availed through online or offline modes.

Interest rate on loan against mutual fund is around 10%-11%, substantially lower than that of personal loans. Loan against mutual funds is similar to overdraft facility offered by banks. While availing loan, investor marks a lien on the units in the name of bank/financial institute, which means that the investor cannot sell or redeem the units.

Most lenders offer up to 50%-60% of the value of mutual fund units in case of equity mutual funds and up to 70%-80% in case of debt funds. The minimum and maximum loan amount offered varies with institutions.

The lien is removed once the loan is repaid. However, in case the investor fails to repay the loan within the specified tenure, the institute has the right to redeem the units to recover the amount.

Should you avail loan against mutual funds?

Loan against mutual funds gives you the leeway to avail cheaper credit, while at the same time, work towards your long-term goal. However, the challenge is that most mutual funds have lost substantial value in the last couple of months amid the volatility in the financial market. Therefore, it may not prove to be a very effective credit avenue.

If the decline in the market value continues, the investor will have to make up for any breach in the loan-to-value ratio.

[Read: Make Mindful Choices of Mutual Fund investments in Current times]

What should you do instead?

As a rule of thumb, availing of loans should be avoided unless you can foresee your financial stress abating in the near term and are confident of a stable flow of income from which you can pay off the loan. If not, you should focus on a prudent budgeting exercise to cut down unnecessary expenditure, such as shopping, entertainment, eating out, etc.

If your expenses are unavoidable and cannot be reduced, make smart use of funds from the contingency reserves built over the years.

[Read: How to Stay Financially Fit In the COVID-19 Lockdown]

What to do if you don't have a contingency fund?

It may be a while before things go back to normal; COVID-19 uncertainties are expected to remain with us for the long haul. Therefore, if you do have a source of income, start building a contingency fund right away.

Ideally, you should have 12-24 months' worth of expenses saved towards contingencies. It may seem too big a contribution, but you can never be certain for how long the difficult times will make its presence felt. You can start by setting up an emergency fund for 3-6 months of your necessary expenses and gradually increase your reserves.

To determine the size of the emergency corpus, you will need to take into account various expenses, such as daily expenses, life, and health insurance premium, EMI if any, and other expenses that absolutely must be met no matter what.

A contingency fund must be easily available to you whenever there is a need. Therefore, contingency fund must be parked in safe and liquid avenues. The purpose of a rainy day fund is not to earn high returns, but to have instant access to fund in case of emergency.

Here are some worthy avenues where you can park contingency fund:

  • Bank savings account

  • Bank Term Deposits

  • Ultra Short and Short term debt funds

  • Liquid Funds

  • Overnight Funds

Managing money smartly is the key to surviving testing times. With mindful budgeting, saving, and investing, you will emerge financially stronger when the crisis ends.

PS: If you wish to select worthy mutual fund schemes, I recommend that you subscribe to PersonalFN's unbiased premium research service, FundSelect.

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If you are serious about investing in a rewarding mutual fund scheme, Subscribe now!

Warm Regards,
Divya Grover
Research Analyst

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