If you are facing a temporary financial crunch, your mutual fund (MF) holdings can come to rescue. Banks accept MF units as collateral, or security, to extend loans.
Tenor: The tenor of the loan is linked to the period of investment in the scheme, if it is a closed-end one. Usually, the tenor gets extended after every quarter, going up to a maximum of five years, in open-ended schemes.
Amount: The amount that banks offer depends upon the net asset value (NAV) of your units and the nature of schemes. For instance, on equity schemes, banks provide loans up to 50% of the NAV, while on debt schemes, including ultra short-term funds and fixed maturity plans, the loan could go up to 80% of the NAV.
Interest rate: It is in the range of 11-16% per annum, depending on the bank.
The time taken to disburse the loan ranges from a few days to few weeks.
How NAV movement affects the loan
What happens if NAV falls: Since banks provide loans up to 50% of the NAV of equity schemes, they enjoy a cushion against any fall in the prices of underlying securities. However, if the value declines drastically, as was the case during the recent downturn, banks may ask for additional units or may ask you to prepay part of your loan. The NAV of debt schemes generally do not change much, hence no such problem arises.
What happens if NAV rises: Most banks offer overdraft facility for loans taken against any security. If the NAV of your scheme rises, it makes you eligible to borrow more from the bank, in case you require additional funds. Usually, this situation arises if you are invested in an equity scheme.
Should you take this loan
This loan is cheaper than personal loans. However, one should avoid taking this loan against debt schemes since the interest charged by banks is usually higher than the returns provided by them. Exiting the scheme and using the proceeds may make more sense even after paying the exit load of 1%.
On the contrary, an equity scheme can generate returns in excess of what the bank charges, especially in the long run.