In the financial world, leveraging investments to meet liquidity needs is a common practice. Loans against shares and loans against mutual funds are two preferred options in this sense. These financial instruments allow investors to access funds without selling their investments.
However, there are distinct differences between the two, each with its own set of advantages and considerations. This article delves into the nuances of loans against mutual funds and loans against shares to help you make an informed decision.
Understanding the Basics
1) Loan Against Mutual Funds: A loan against mutual funds allows investors to borrow money by pledging their mutual fund units as collateral. These loans are typically sanctioned as an overdraft facility, where the borrower can withdraw funds up to a certain limit based on the value of the pledged mutual fund units. Usually, between 50% and 70% of the mutual funds’ net asset value (NAV) is used as the loan amount.
2) Loan Against Shares: Similarly, a loan against shares enables investors to borrow funds by pledging their equity shares as collateral. The loan amount in this case is also a percentage of the market value of the pledged shares, generally ranging from 50% to 60%. These loans are also provided as an overdraft facility, allowing flexible withdrawals up to the sanctioned limit.
Key Differences
- Valuation and Liquidity:
- Because mutual funds are diversified, they are typically thought to be less volatile than individual shares. This makes the valuation of mutual funds relatively stable, providing a more predictable collateral value.
- Shares, on the other hand, can be highly volatile, leading to frequent fluctuations in their market value. This can affect the loan amount that can be sanctioned, making loans against shares slightly riskier.
- Loan-to-Value (LTV) Ratio:
- When compared to loans against shares, loans secured by mutual funds usually have a higher loan-to-value ratio. It implies that you have the option to borrow a higher percentage of the value of your mutual fund units rather than against your stock.
- The lower LTV ratio for shares is due to the higher risk associated with market volatility.
- Interest Rates:
- The interest rates for loans against mutual funds are generally lower compared to loans against shares. This is because mutual funds are considered less risky due to their diversified nature.
- Loans against shares carry a higher interest rate to compensate for the increased risk of market fluctuations affecting the value of the collateral.
- Documentation and Approval Process:
- The documentation process for loans against mutual funds is typically simpler and quicker. This is because mutual funds are managed by professional fund managers and have a more straightforward valuation process.
- Loans against shares may require more documentation and a longer approval process, especially if the shares are of lesser-known companies or if there is high volatility in the market.
- Impact of Market Fluctuations:
- Mutual fund values are less susceptible to drastic changes due to their diversified portfolio. Hence, loans against mutual funds are less likely to be affected by market volatility.
- Loans against shares are directly impacted by market conditions. A sudden drop in share prices can lead to a margin call, where the borrower might need to provide additional collateral or repay part of the loan.
Advantages and Disadvantages
Loan Against Mutual Funds:
Advantages:
- Lower interest rates due to reduced risk.
- Higher LTV ratio, allowing for more funds to be borrowed.
- Simplified documentation and quicker approval process.
- Less affected by market volatility, offering more stability.
Disadvantages:
- Limited to the value of mutual fund units, which might not be as high as the value of shares in some cases.
- The borrower might lose out on potential high returns from the mutual funds if the market performs exceptionally well.
Loan Against Shares:
Advantages:
- Potential for higher loan amounts if the value of shares is significant.
- Flexibility to leverage high-performing shares for liquidity.
- Suitable for investors with a high-value portfolio of shares.
Disadvantages:
- Higher interest rates due to increased risk.
- Lower LTV ratio, meaning a lower percentage of the share value can be borrowed.
- Greater impact from market volatility, increasing the risk of margin calls.
Which Option to Choose?
The choice between a loan against mutual funds and a loan against shares depends largely on individual financial circumstances, risk appetite, and the composition of the investment portfolio.
If stability and lower interest rates are your priorities, a loan against mutual funds might be the better option. Higher LTV ratios and the predictable nature of mutual fund valuations can make funding sources more dependable.
However, if you have a high-value portfolio of shares and are confident in their performance, a loan against shares could offer higher loan amounts and the flexibility to leverage your equity investments for liquidity needs.
In conclusion
both loans against mutual funds and loans against shares have their unique advantages and considerations. It’s essential to evaluate your financial needs, the composition of your investment portfolio, and your risk tolerance before making a decision.
Consulting with a financial advisor can also provide valuable insights tailored to your specific situation, ensuring you make the most informed choice for your liquidity needs.
