Financial Emergency: Is Taking a Loan Against Mutual Fund Units Better Than Redeeming Them?

Importance of Emergency Fund

Before we discuss loans against mutual fund (LAMF) units versus redeeming them, let us take a moment to discuss the importance of an emergency fund. Having an emergency fund equivalent to 3 to 6 months of expenses can save us from choosing between a LAMF units versus redeeming them. Many individuals don't maintain an emergency fund and hence land up in such a situation wherein they have to choose between selling their assets or taking a loan against them.

What Is a Loan Against Mutual Fund Units?

A loan against mutual fund (LAMF) units is a secured loan wherein you can borrow money by offering your mutual fund units as security/collateral. You will have to pledge the mutual fund units with the bank or NBFC. A lien will be marked on the pledged mutual fund units, and as a result, you will not be able to redeem or transfer them till the loan is repaid.

The loan amount will depend on the value of the mutual fund units (Number of MF units X Net Asset Value per unit). You will not get a loan for 100% of the value of the mutual fund units. The loan amount is determined based on the type of the mutual fund scheme and the loan to value (LTV).

For example, a bank or NBFC may have an LTV of 50% for equity mutual fund schemes. In such a scenario, for every Rs. 100 worth of MF units offered as collateral, you will get a loan of only Rs. 50. In the case of hybrid schemes, the LTV may be higher, at, say, 60%. The LTV may be even higher for debt schemes, at, say, 70%.

Usually, a loan against mutual fund units is given as a credit line. For example, suppose you have been given a credit line of Rs. 1 lakh. You can withdraw the money as and when required. You will have to pay the interest only for the amount withdrawn and for the number of days used. The credit line tenure is usually one year and must be renewed.

Mutual Fund Units: Loan Versus Redeeming Them

Now let us compare taking a loan against mutual fund units versus redeeming them.

Mutual Fund Unit Benefits

When you take a LAMF units, even though you have offered the MF units as collateral to the bank/NBFC, you continue to own them. In such a scenario, you continue to enjoy the dividends, capital appreciation, and any other corporate action benefits. But if you redeem mutual fund units, you will not get any of their benefits in future.

Tenure

If your loan requirement is for a shorter tenure of up to one year, it is preferable to take a loan against your mutual fund units instead of redeeming them. It is better to meet the short-term monetary requirement through a loan rather than redeeming units meant for your long-term financial goals.

Interest Paid vs Capital Gain Potential

The loan against MF units is a secured loan. Hence, the interest rate is lower than unsecured loans like personal loans and credit card loans. If the stock markets are doing well, the potential capital gain on the pledged equity mutual fund units may equal or even better the interest paid.

Even if the capital gain is lower or negative during the loan period, it has the potential to make up for it in the long run. Hence, it may be better to go for a loan rather than redeeming the equity mutual fund units.

If the interest rate on the loan is higher than the expected return from the mutual fund units, it may make sense to redeem them. For example, the returns from debt funds are usually lower than the interest rate on loans against mutual fund units. In such a scenario, you will pay a higher interest rate on the loan (for example, 10% p.a.) than the return on debt funds (for example, 8% p.a.). Hence, redeeming the units may make sense rather than taking a loan against them. When redeeming the units, consider the exit load (if any) and capital gain tax implications.

Emergency Fund: A Long-Term Solution to Financial Emergencies

As a long-term solution to financial emergencies, you should build and maintain an emergency fund. Whenever the need arises, you can dip into it and get over the situation. You should immediately work towards replenishing the emergency fund whenever you dip into it. You should review the emergency fund amount regularly based on past experiences of dipping into it. 

Along with an emergency fund, have adequate health insurance for the entire family to protect yourself from hospitalisation bills. Also, if your existing debt (personal loans and credit card outstanding) is higher, work with an investment expert and make a deleveraging plan.

Resist the Temptation to Redeem Mutual Fund Units for Short-Term Financial Emergencies

Redeeming mutual funds is very easy. The units can be redeemed at the click of a button, and the money is credited to your bank account in one to two days. So, whenever you have a short-term emergency funding requirement, you may get tempted to redeem mutual fund units. However, you should resist the temptation to redeem mutual fund units that you are accumulating for your long-term financial goals. If you redeem them, even if partially, you may not be able to achieve your financial goals.

To alleviate short-term pain (financial emergency), it is easy to lose sight of long-term gains (financial goals fulfilment). There is no better joy than fulfilling financial goals and achieving financial freedom. Your equity mutual funds are the gateway to your financial freedom. So, preserve and treasure them as much as possible. A LAMF can help you tide over short-term financial emergencies, and at the same time, the mutual fund units can keep your financial planning journey intact.