Mutual funds are a popular investment tool among investors who are looking for a diversified portfolio with a relatively low risk profile. However, some investors may face unexpected financial emergencies or may want to take advantage of a new investment opportunity but may not have the cash they need to capitalize on it. In such cases, loans against mutual funds can be a viable option for investors. This article will explore the impact of loans against mutual funds on investment returns, and how investors can make informed decisions when considering such loans.
What are Loans Against Mutual Funds?
Investors can borrow money against the value of their mutual fund holdings with loans against mutual funds offered by banks and non-banking financial companies (NBFCs). This loan is given as a percentage of the market value of the mutual funds. The loan amount can be used for any purpose, including paying off debts, home renovation, funding education, emergency expenses, etc.
In most cases, investors can borrow up to 50% of the value of their mutual fund holdings. The loan is structured as a lien against the mutual fund units, which means that the lender has the right to sell the mutual fund units to recover the loan amount in case of default by the borrower.
Impacts of loans against mutual funds on investment returns.
1) Reduction in investment returns
Taking a loan against mutual funds means that a significant portion of the investment portfolio is locked up in the form of a loan. This can reduce the returns generated from the mutual fund investments, as the amount of money invested in mutual funds is less.
Moreover, the loan against mutual funds interest rate are typically higher than regular loans, which can eat into the returns generated by the investments. If the mutual funds generate returns that are less than the interest rate of the loan, the borrower will end up in a net loss position.
2) Risk of Margin Calls
Margin calls are a risk factor associated with loans against mutual funds. If the value of the mutual funds declines significantly, the lender may ask the borrower to pledge additional mutual fund units or pay back the loan amount. This can lead to a forced sale of mutual fund units at an unfavorable time, thereby reducing the overall investment returns.
3) Reduced Flexibility in Investment Options
Once the mutual funds are pledged as collateral for loans, the flexibility of the borrower to sell or switch the mutual fund units is reduced. This is because any such transaction can trigger a margin call or reduction in the loan amount. This reduces flexibility and can make it difficult for the borrower to make timely adjustments to their portfolio.
How to Invest Safely Using Mutual Fund Loan
Despite the risks, mutual fund loans can be a viable option for investors who need access to capital for various reasons. Below are some tips for investors to help minimize the risk of mutual fund loans.
1) Consider the interest rate
Before taking a mutual fund loan, investors should compare the interest rates of different lenders and select the one that offers the lowest rate. The lower the interest rate, the higher the returns from the mutual funds will be.
2) Invest in liquid and high-return funds
Investors should consider investing in funds that are highly liquid, such as large-cap equity funds and debt funds with short-term maturities, as these funds have lower volatility and are more stable. Funds with a good track record of returns will also ensure that the net returns are higher than the interest rate of the loan.
3) Be aware of the risks
Investors must be aware of the risks associated with mutual fund loans, such as the risk of margin calls, loss of potential capital gains on mutual fund investments, and reduced flexibility in making changes to their portfolio.
Mutual funds are a popular investment tool among investors that offer a diversified portfolio with a relatively low risk profile. However, some investors may face unexpected financial emergencies or may want to take advantage of a new investment opportunity but may not have the cash they need to capitalize on it. In such cases, loans against mutual funds can be a viable option for investors. These financial products enable investors to borrow money against the value of their mutual fund holdings. However, taking loans against mutual funds can reduce returns generated by mutual fund investments and reduce flexibility in making changes to an investment portfolio. Investors must compare interest rates and invest in high-return and liquid funds to minimize risks.