A few days ago, my cousin reached out with a concern. There was a medical emergency, but the hospital bill was steep, and with no insurance, he was looking for ways to pay. He considered taking a loan against his mutual funds to cover the Rs 30 lakh cost, since he didn’t want to sell his investments.
This conversation made me realize that many people are turning to loans against their mutual funds for various reasons—whether to handle emergencies or other expenses. A Certified Financial Planner, often tell clients to carefully consider all options before making such decisions. While loans may seem convenient, they might not always be the best financial choice. Let’s explore why.
Why Loan against Mutual Funds Can Be Risky?
Many think they’re keeping their wealth intact by pledging mutual funds. However, taking a loan increases your liabilities, which ultimately reduces your net worth.
For instance, if you borrow Rs 30 lakh at 12% interest, you’ll end up paying back Rs 40.8 lakh over three years. This means your net worth takes a hit of over Rs 40 lakh, even though you only needed Rs 30 lakh. Additionally, there are processing fees and other charges that further increase the total cost of the loan.
People hesitate to redeem their mutual funds because they’re seeing good returns. But as many Financial Advisors would recommend, it’s crucial to remember that mutual funds are market-linked, meaning past returns don’t guarantee future performance. By holding onto the loan, you might end up paying more in interest than you could ever earn through potential returns.
Instead, selling your mutual funds doesn’t stop you from reinvesting and benefiting from future growth. You can always restart investing through SIPs (Systematic Investment Plans), which can help you rebuild your wealth over time.
When you take a loan against your mutual funds, you don’t get the full value of your investment. Lenders typically offer only 50% of the value of equity funds and 25% for debt funds. So, to get Rs 30 lakh, you may need to pledge more than what you need, and you won’t have access to the remaining funds until the loan is repaid.
If the market drops after you’ve pledged your mutual funds, you might face a margin call. This means the lender will ask you to provide additional funds to maintain the loan-to-value ratio. If the market falls significantly, you could end up having to pay back a portion of the loan right away.
When Could a Loan Against Mutual Funds Make Sense?
In rare situations, a loan against mutual funds could make sense, especially if you need money for a very short period (like a week or a month). The interest you pay could be lower than the taxes you would incur by redeeming the funds. However, it’s important to consult with a financial planner to carefully compare the costs and evaluate the best option according to your financial situation.
Final Thoughts
Taking a loan against mutual funds may seem like a quick fix, but in many cases, redeeming them is a smarter financial decision. Redeeming your funds gives you immediate liquidity, while also protecting your long-term wealth. Always weigh your options carefully and consult with a trusted financial professional if you’re unsure. Only consider a loan if it’s for a very short-term need and you’ve thoroughly evaluated all the costs involved.
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– Shrees Haralkar, Associate FP.