Why Pledging Mutual Funds is a Smart Alternative to Personal Loans

When faced with an urgent financial need, people often resort to personal loans due to their quick processing and minimal collateral requirements. However, a lesser-known yet highly efficient alternative exists: pledging mutual funds. 

This financing option allows investors to leverage their existing investments without liquidating them. In this article, we will explore why pledging mutual funds is a smarter choice compared to traditional personal loans.

Understanding Pledging of Mutual Funds

Pledging mutual funds refers to using your mutual fund holdings as collateral to secure a loan. Instead of selling your investments and losing out on potential future gains, you can approach a bank or a non-banking financial company (NBFC) to obtain funds while keeping your investment intact. The lender assesses the value of your mutual fund units and grants a loan based on the loan-to-value (LTV) ratio.

Comparing Pledging Mutual Funds and Personal Loans

To understand why pledging mutual funds is a smarter alternative, let's compare it to personal loans across several parameters:

1. Interest Rates: Lower Cost of Borrowing

One of the biggest advantages of pledging mutual funds over personal loans is the significantly lower interest rates. Personal loans typically come with interest rates ranging from 10% to 24% per annum, depending on the borrower's creditworthiness and the lender’s terms. In contrast, loan against mutual funds generally carry interest rates between 7% and 12%, making them a much more affordable borrowing option.

2. No Need for High Credit Scores

Personal loans are unsecured, meaning that lenders heavily rely on the applicant’s credit score to assess eligibility and interest rates. Borrowers with lower credit scores often face rejections or end up paying higher interest rates. On the other hand, pledging mutual funds requires minimal credit evaluation since the loan is secured by the investment itself. This makes it easier for individuals with a low or moderate credit score to access funds.

3. Quick Processing and Minimal Documentation

Many people opt for personal loans due to their quick approval process, but loans against mutual funds can be just as swift. Since the lender already has collateral in the form of mutual fund holdings, the loan is processed quickly with minimal documentation. The borrower simply needs to provide details of their mutual fund holdings, KYC documents, and a loan agreement, making the process seamless and hassle-free.

4. No Immediate Liquidation of Assets

Selling mutual fund investments to meet financial needs might seem like an easy solution, but it comes with drawbacks such as tax implications and potential loss of future gains. When you pledge mutual funds, you retain ownership of the units and continue earning potential returns. This allows you to ride out market fluctuations without disrupting your long-term financial goals.

5. Flexibility in Loan Repayment

Loans against mutual funds offer greater flexibility in repayment compared to personal loans. Borrowers can choose between structured EMIs or opting for interest-only payments during the tenure while repaying the principal amount later. Personal loans, in contrast, have fixed EMIs that must be paid monthly, adding pressure on borrowers to meet strict repayment schedules.

6. Higher Loan Eligibility

With personal loans, the maximum loan amount depends on the borrower’s income and creditworthiness, which might restrict borrowing capacity. However, loans against mutual funds are based on the LTV ratio, typically ranging between 50% and 80% of the investment value. If you have a significant mutual fund portfolio, you may be eligible for a larger loan amount without any income constraints.

7. No Prepayment Penalties

Many personal loans impose prepayment penalties if the borrower wishes to repay the loan before the tenure ends. In contrast, most lenders offering loans against mutual funds do not charge such penalties, allowing borrowers to close their loans early without incurring extra costs.

Potential Risks to Consider

While pledging mutual funds has many advantages, it is essential to consider potential risks before making a decision:

• Market Fluctuations: Since mutual fund investments are subject to market risks, a significant drop in value could lead to margin calls, requiring borrowers to provide additional collateral or repay a portion of the loan.

• LTV Restrictions: The loan amount is dependent on the LTV ratio, which varies based on fund categories. Equity mutual funds usually have a lower LTV than debt funds due to their volatility.

• Loss of Units in Case of Default: If a borrower fails to repay the loan, the lender has the right to sell the pledged mutual fund units to recover the outstanding amount.

How to Pledge Mutual Funds for a Loan

If you decide that pledging mutual funds is the right option for you, follow these simple steps:

1. Choose a Lender: Compare different banks and NBFCs offering loans against mutual funds and select the one with the best interest rates and terms.

2. Initiate the Pledge Process: Log in to your mutual fund account and initiate the pledging process by selecting the units you want to pledge. Some lenders allow online pledging, making the process more convenient.

3. Submit Required Documents: Provide your KYC documents, loan application, and mutual fund pledge details to the lender.

4. Loan Disbursement: Once the lender approves the pledge, the loan amount is disbursed into your account, usually within a day or two.

5. Repay and Release Pledge: Make regular interest payments, and upon full repayment of the loan, the pledged mutual fund units are released back to you.

When Should You Choose Pledging Mutual Funds Over a Personal Loan?

Pledging mutual funds is ideal when:

• You need immediate funds but do not want to liquidate your investments.

• You are looking for a lower interest rate loan option.

• Your credit score is not high enough for a personal loan.

• You have a sizable mutual fund portfolio and can leverage it for financing needs.

Conclusion

While personal loans are a popular choice for financial emergencies, pledging mutual funds offers a smarter and more cost-effective alternative. With lower interest rates, flexible repayment options, and the ability to retain ownership of investments, this option allows borrowers to meet their financial needs without disrupting long-term wealth creation. 

However, it is essential to assess your risk appetite and ensure you can manage repayments to avoid potential liquidation of assets. By making an informed choice, you can leverage your mutual fund investments effectively while securing funds in times of need.