Mutual Funds as Collateral: Benefits and Considerations Explained

Mutual funds have become a preferred investment choice for many individuals due to their potential for long-term capital appreciation and wealth creation. However, rather than liquidating investments to meet financial needs, investors can pledge their mutual funds as collateral to obtain a loan.

By leveraging mutual fund units, borrowers can secure financing at competitive interest rates while maintaining their investment portfolio. Many financial institutions offer loans against mutual funds with flexible repayment terms, making this an attractive option for those seeking liquidity without disrupting their long-term financial plans.

Understanding how mutual funds can be used as collateral, along with their advantages and risks, can help investors make informed decisions before pledging their assets.

What does using mutual funds as collateral mean?

Using mutual funds as collateral refers to the process of pledging mutual fund units to a lender in exchange for a loan. Instead of liquidating investments, investors can continue holding their mutual fund units while using them as security for borrowed funds.

Lenders assess the value of the pledged mutual fund units and offer a loan based on a predefined loan-to-value (LTV) ratio, typically ranging from 50% to 80% of the net asset value (NAV) of the mutual fund holdings. Equity mutual funds generally have a lower LTV ratio due to market volatility, whereas debt mutual funds may offer a higher LTV ratio as they are considered more stable.

The borrower retains ownership of the mutual fund units but cannot redeem or sell them while they are pledged. If the borrower fails to repay the loan, the lender has the right to liquidate the pledged units to recover the outstanding amount.

Advantages of using mutual funds as collateral

Access to liquidity without selling investments – Investors can meet urgent financial needs without redeeming their mutual fund holdings.

Lower interest rates compared to unsecured loans – Since the loan is secured by mutual funds, interest rates are generally lower than personal loans or credit card borrowing.

Continued investment growth – Borrowers benefit from potential capital appreciation and dividend payouts while the mutual fund units remain pledged.

Flexible repayment options – Lenders offer various repayment plans, including EMIs, bullet payments, and overdraft facilities.

No impact on credit score if repaid on time – Since the loan is backed by collateral, timely repayment does not negatively impact the borrower’s credit rating.

Quick loan approval process – Loans against mutual funds require minimal documentation and are processed faster than traditional secured loans.

For more details on this financing option, read our guide on loan against mutual funds.

Considerations when using mutual funds as collateral

Market volatility risk – Equity mutual funds are subject to market fluctuations, which can affect the LTV ratio and may lead to margin calls from the lender.

Loan-to-value (LTV) ratio limitations – Lenders offer loans based on a percentage of the mutual fund’s NAV, which may limit the available loan amount.

Restriction on fund transactions – Pledged mutual funds cannot be redeemed or switched until the loan is fully repaid.

Potential liquidation by lender – If the borrower defaults or fails to maintain the required margin, the lender may sell the pledged units to recover the loan.

Impact on investment strategy – Using mutual funds as collateral may disrupt long-term investment plans if the borrower is unable to maintain the pledged funds.

Interest costs – While interest rates are lower than unsecured loans, borrowers must ensure they can afford the repayment to avoid financial strain.

Types of loans secured by mutual funds

Term loans – Borrowers receive a lump sum loan amount against pledged mutual fund units with a fixed tenure and repayment schedule.

Overdraft facility – A flexible credit line where the borrower can withdraw funds as needed, paying interest only on the utilised amount.

Margin loans – Investors can pledge mutual funds to secure additional funds for trading or investing in stock markets.

Business loans – Small businesses and self-employed individuals can use mutual funds as collateral to secure working capital or business expansion loans.

Emergency loans – Instant loans against mutual funds provide quick financial assistance for medical expenses, education fees, or other urgent needs.

Conclusion

Using mutual funds as collateral is a smart financial strategy for investors seeking liquidity without selling their investments. It allows individuals to leverage their existing assets, access funds at lower interest rates, and continue benefiting from market appreciation.

However, borrowers must carefully evaluate the risks associated with market fluctuations, repayment obligations, and restrictions on fund transactions before pledging their mutual fund units. Choosing the right type of loan, understanding the LTV ratio, and maintaining financial discipline can help investors make the most of this financing option without disrupting their long-term investment goals.