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Some believe that if they need money urgently, their only choice is to withdraw their mutual fund investment. This is not true, as there are circumstances where banks and financial institutions provide loans against mutual fund investments. The investment is not withdrawn, but it is locked for a short period of time against the loan taken.
It’s a bit like taking a loan against property or gold. The lender accepts the investment as collateral and gives the borrower a loan based on its value.
The mutual fund units are pledged, not sold
When someone takes this type of loan, the mutual fund units are not redeemed. Instead, the lender places what’s called a lien on them. In practical terms, that just means the units are temporarily locked.
The investor still technically owns them, and they continue to remain invested in the fund. However, they cannot redeem or transfer those units until the loan has been repaid and the lien is removed.
For people who believe their investments will grow over time, this can be preferable to selling them during a temporary cash need.
The loan amount depends on the investment value
The amount of loan that can be taken is not usually the full amount of investment. Rather, a portion of that amount is given.
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Suppose a person is holding a mutual fund investment of ₹1 lakh. He can borrow half to two-thirds of that amount from a bank.
Debt mutual funds are usually not treated in the same way as equity mutual funds because their NAVs fluctuate less.
The interest rate is usually lower
The amount is an investment loan. Hence, a lower rate of interest is charged on it. The rate of interest is lower because it is an investment loan. However, it is still a loan. Hence, interest is charged on the amount borrowed.
If a borrower is not able to repay the loan, he can redeem the mutual fund units to recover his loan amount.
It can help avoid selling investments during bad markets
This option can prove beneficial for the investor as it can help him avoid selling mutual fund units in the market. Selling mutual fund units at the time of a market dip can prove costly for the investor. By taking a loan, he can avoid this.
It is best used as a short-term solution
Loans against mutual funds are generally taken for short-term needs rather than long-term needs. The value of equity mutual funds fluctuates frequently.
If the market falls sharply, the borrower may sometimes be asked to repay part of the loan or pledge additional units.
For investors who already have mutual fund holdings, this type of loan can provide flexibility. It allows access to cash without immediately breaking long-term investments. Still, like any borrowing decision, it works best when used carefully and with a clear repayment plan.