Mutual funds cater to a wide range of investors. They create a portfolio of securities from the money pooled in by different investors, and professional fund managers make the investment decisions.
Mutual funds charge certain expenses through the scheme’s Total Expense Ratio (TER). This includes fund management fees, selling and distribution costs, investor awareness expenses, etc. Most of these expenses, and even the aggregate TER, are under the oversight of SEBI (Securities & Exchange Board of India), and they are subject to specified limits under SEBI guidelines.
Investors can invest in mutual funds either through lumpsum mode or Systematic Investment Plan (SIP). Under an SIP, investors can make periodic investments in mutual fund schemes of their choice. The instalment is automatically deducted from the bank account on the set date and invested in the specified mutual fund scheme. Thus, SIP enables investors to take small but disciplined steps towards their financial goals.
In case of any financial emergency, the first thought is to stop making fresh investments or liquidating existing investments. However, taking such a step can be counterproductive, as liquidating mutual fund investments linked to specific goals can disrupt overall financial plans.
Further, redeeming investments before their specified expiry may also attract exit loads, thereby lowering the existing portfolio returns. Additionally, any redemption of mutual fund investments requires tax incidence to be taken care of with respect to income tax guidelines.
In such cases, one may consider availing of loans against mutual fund schemes, by keeping the mutual fund units as collateral. This takes care of the temporary cash flow problems and allows the mutual fund investments to continue growing depending upon the performance of the underlying portfolio.
Further, the investors’ financial plans remain on track since investments remain linked with specific financial goals. Here are some crucial investment considerations one must make before deciding to avail of a loan against mutual fund schemes:
Loan amount that can be availed
In the case of loans against mutual fund schemes, the borrower's income may not be considered while calculating the eligible loan amount. The primary criterion to calculate such a loan amount is the value of mutual fund units pledged as security.
The Loan-to-Value (LTV) ratio is generally 50% for equity funds and around 70-80% for debt funds. Lower LTV for equity funds is due to the inherent volatility of equity markets over the short term.
The margin of safety in the loan amount and investment valuation protects the lenders against any adverse movements in the portfolio valuation.
Interest rates on loans against mutual fund units
Since such loans are secured with mutual fund units as collateral, they have a lower interest rate than an unsecured loan. This is because the credit risk for the lender is limited, as, in case of default, the lender can liquidate the security and recover its dues.
Applying for the loan
One needs to approach the bank and share the mutual fund statements with the lender. Once the lender has completed the initial due diligence and documentation formalities, an application form will be sent to the mutual fund Registrar & Transfer Agent (R&TA) to mark the lien in the lender's favour. And after the process is completed, the lender will disburse the loan as per the eligible sanction amount.
What happens in case of default?
Since mutual fund units are pledged as security towards the loan, the lender will liquidate the fund units to recover their amount due along with interest. Since mutual fund units can also be liquidated in fractions, the lender may liquidate sufficient units to recover the amounts.
If the lender has realised a higher amount against such redemption due to the change in mutual fund NAV (Net Asset Value), the lender will refund the excess amount to the borrower.
Tax incidence on pledging mutual fund units
Under the Indian Income Tax laws, mutual fund investments are taxed when capital gains are realised. If mutual fund units are pledged for availing loans, there is no tax incidence at that point.
However, in case of a default in repayment, the lender liquidates the mutual fund units pledged as security against the loan. In such a case, one would be liable to take care of the tax implications of such a sale.
Capital gains are generally calculated by deducting the investment cost from the redemption value of mutual fund investments. However, for Long-Term Capital Gains for debt fund investments held for 36 months or more, one can also benefit from indexation while calculating the gains, thereby ultimately lowering the effective tax rate.
Note: The tax provisions, as mentioned in the article, are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.
Disclaimer-
This article is for educational purpose only. Investors may refer to the specific terms and conditions for loan against mutual fund as prescribed by the lender.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
To know about the KYC documentary requirements and procedure for change of address, phone number, bank details, etc. please visit https://www.utimf.com/servicerequest/kyc. Please deal with only registered Mutual funds, details of which can be verified on the SEBI website under "Intermediaries/market Infrastructure Institutions". All complaints regarding UTI Mutual Fund can be directed towards service@uti.co.in and/or visit www.scores.gov.in (SEBI SCORES portal). This material is part of Investor Education and awareness initiative of UTI Mutual Fund.