How is the Credit Limit determined for Loan Against Mutual Funds

Choosing a loan secured by your investments is a smart move if you need money but don't want to sell your investments. With this kind of loan, you might still profit from your investments while borrowing against the value of your Mutual Fund units.  This blog post will discuss the key benefits of Loan Against Mutual Funds as well as how lenders set the credit limit for these loans.

Why take a Loan Against Mutual Funds?

Swift Access to Funds

Taking a Loan Against Mutual Funds provides you with access to cash without having to sell your Mutual Fund (MF) holdings. This is especially useful when you need short-term liquidity but want to keep your long-term financial goals on track. In times of emergencies or unexpected financial demands, this option proves valuable as it allows you to manage your finances without compromising on potential returns.

Preservation of Investment Growth

One notable benefit of this borrowing option is that your Mutual Fund investments can continue generating returns while they are being used as collateral for the loan. You can still benefit from capital gains and dividends while using the Mutual Fund units as collateral. This helps you to address immediate financial needs while keeping your investment portfolio on track for long-term growth.

Advantageous Interest Rates

Compared to unsecured loans, a Loan Against Mutual Funds generally comes with lower interest rates. Since the MF units serve as collateral, lenders consider these loans less risky, which results in more favourable rates. This makes it a cost-efficient borrowing option when compared to unsecured forms of credit.

Flexible Repayment Choices

Loan Against Mutual Funds offers repayment flexibility. As these loans are provided as an overdraft, borrowers are required to pay only the interest component on the due date. The outstanding principal can be repaid at any time based on their convenience or when surplus funds are available. This repayment structure gives borrowers greater control over their finances.

No Charges for Pre-payment

Many lenders do not levy penalties for repaying the loan ahead of schedule, i.e. pre-paying the loan, adding to the flexibility of the loan. If your financial situation improves, you can foreclose the loan without worrying about additional charges, ultimately helping you save on interest costs.

Positive Impact on Credit Score

Since Loan Against Mutual Funds is backed by your MF units as security, there is a reduced risk of default. If handled responsibly, it won't have an impact on your credit score. Making repayments on time will also assist in maintaining or enhancing your credit standing since secured loans are generally viewed favourably by credit agencies.

How Do Lenders Determine the Credit Limit for Loans Against Mutual Funds?

The credit limit of a Loan Against Mutual Funds is determined by several factors. Here are the key factors:

Type of Mutual Funds

The type of Mutual Funds you own plays a significant role in determining the loan amount you can obtain. Equity Mutual Funds have a loan-to-value (LTV) ratio of up to 50% of the Fund’s NAV, as they are considered riskier due to market fluctuations. On the other hand, Debt Mutual Funds, which are less volatile, might offer an LTV ratio of up to 80% of the Fund's NAV. It's important to note that only Mutual Funds approved by the Bank can be pledged as collateral. Lenders view Debt Funds as more stable investments compared to Equity Funds.

Loan to Value Ratio

The LTV ratio represents the proportion of your fund's market value that lenders are willing to provide as a loan. For example, if your investment portfolio is valued at ₹ 10 lakh and the lender offers an LTV ratio of 50%, you could be eligible for a loan of ₹ 5 lakh. Due to their market volatility, Equity Funds typically have an LTV ratio of up to 50% of the NAV, while stable Debt Funds have an LTV ratio of up to 80% of the NAV. 

Lender’s Policies

Lenders have varying policies when it comes to loan amounts and these are often influenced by the type and value of the Mutual Funds pledged as security. It’s essential to compare lenders and select one that offers terms suited to your needs. Lenders might also have different rules about repayment frequency, interest rates and additional fees, all of which can affect the total borrowing cost.

Credit Score

When using Mutual Funds as collateral, lenders may still check your credit score, primarily to assess your repayment history and financial reliability. While it doesn't directly impact the loan amount or interest rate, a higher credit score reflects a better track record of managing credit.

Current Market Conditions

During volatile market conditions, lenders may reduce loan amounts to manage risk. In such circumstances, you might still qualify for a loan, but lenders may adjust the credit limit based on changes in the NAV of your Mutual Fund. If the market conditions worsen, lenders might request additional collateral or partial repayment to secure the loan.

Here is a breakdown of the loan limits for Loans Against Mutual Funds for various amounts:

Conclusion

Taking a Loan Against Mutual Funds is a great way to get liquidity without disturbing your investment portfolio. The credit limit of this type of loan is influenced by factors such as the type of Mutual Funds you hold, the LTV ratio, market conditions and the lender's policies. Understanding how these factors impact your loan limit can help you manage your loan effectively. It's essential to compare lenders, evaluate their interest rates and fully understand their terms to ensure that you're securing a fair deal. Stay proactive by monitoring the loan terms and keeping an eye on market conditions that could impact the value of your Funds and consequently, your loan amount.