Compare the returns, after factoring in penalties, with the interest rate of the loan
Other factors you should consider are the amount and tenure of the loan and your repayment capacity
The covid-19 crisis has hit many people hard, resulting in a cash crunch for people who have lost jobs or taken pay cuts or whose businesses have suffered. If you are looking for funds on a short notice, personal loans and credit cards may seem to be the immediate solution, but they come with high interest rates. What you can instead look at is taking loans against assets or securities such as life insurance policies, mutual funds, gold or property you own. Such loans, typically, charge a lower interest rate as they are backed up by an asset.
But there may be situations when liquidating these assets may make more sense than taking a loan against them or taking any other loan for that matter. Read on to know more.
Loans against securities are usually offered as an overdraft facility. This means a loan amount will be sanctioned to you by the bank and you can avail of that amount either in full or in one or more tranches. Many banks are offering loans against securities online.
You, typically, need to provide the security to the bank to avail of the loan. To take loans against shares, National Savings Certificate (NSC) and Kisan Vikas Patra (KVP), you may also need to have a demat account with the bank.
The interest rate is, typically, charged on the amount of outstanding loan at the end of every month. The loan amount and interest rate may vary depending on the profile of the person, type of security and tenure. “Since you are providing a collateral to the bank, the bank will be willing to extend credit even if you do not have a good credit score. However, if you have too many defaults or have been tardy in repaying your other loans, then the lender may charge a much higher interest rate on the loan and give you a much smaller loan in proportion to the value of the asset or security, or both," said Adhil Shetty, CEO and co-founder, BankBazaar.com, an online marketplace for financial instruments.
These are, typically, cheaper than personal loans. For instance, interest rates on personal loans can be in the range of 12-24% per annum or more, but loans against securities are currently available in the range of 9.25-12% per annum. Also, loan against property is available at a relatively lower rate of less than 9% per annum (see graph).
However, there are other costs to factor in, too. For instance, HDFC Bank Ltd charges a flat processing fee of ₹1,499 if you apply online for a loan against mutual funds or bonds. In case of the offline process, the charge is 1% of the sanctioned amount or ₹3,500, whichever is higher. Apart from that, the bank also charges annual maintenance charges of up to 0.50% of the sanctioned credit limit, subject to a minimum of ₹1,000 and maximum of ₹5,000. Then there are charges like stamp duty, statutory charges, prepayment cost and so on.
Loans against securities are usually given for a year and if you want to extend the loan, you may have to pay renewal charges. For instance, ICICI Bank Ltd charges ₹2,500 per annum for renewal at the end of each year. These charges exclude the goods and services tax (GST).
What should you do?
Ideally, you should have an emergency fund, but if you are in a situation where you need money, you should first evaluate the options you have. Compare the interest rate on loans against various securities and assets, and go for the one which is available at the lowest rate.
Also, compare the interest rate on the loan with the return from the asset. Usually, it would make more sense to liquidate the asset if the interest rate on the loan is higher. But this may not be true for all assets.
There may be penalty charges to factor in before liquidating an asset. For instance, in case of an insurance policy, surrender charges are usually high in the first few years of buying the policy. In this case, taking a loan against the policy could be a better idea even if you think the rate of interest on the loan is higher than the return on the policy. Do a cost-benefit analysis to find out.
Similarly, if you have a fixed deposit of ₹10 lakh and need just ₹1 lakh for a short period, you may end up paying a higher penalty for breaking the entire FD. In this case, taking a loan against the FD may be more feasible.
When it comes to shares and equity mutual funds, it doesn’t make sense to liquidate them when markets are in a downfall and your investments have lost considerable value, which is the case currently. Instead of selling your MFs or shares at a loss, you may consider taking a loan and retain your units. However, remember that it is not possible to get a loan against the shares of all the companies or all mutual funds. Typically, banks and lending institutions have their own list of companies and mutual funds schemes against which they offer loans.
In all this, remember that these loans may help you only if you need money for the short term. “Loans against securities are best for tiding over short-term financial emergencies only. Bear in mind that you are pledging your investments here. The bank can attach your FDs or mutual funds in case of defaults," said Shetty.
Also, be careful about the terms and conditions of such loans. Take the case of loans against life insurance policies. “If the interest (amount) on the loan against insurance exceeds the surrender value of the loan, then you may no longer get the insurance cover from the assigned policy," said Shetty. In other words, your insurance benefits under the policy may cease to exist temporarily. It may not be in your best interest to put your insurance cover at stake in such difficult times.
While some experts are in favour of taking a loan against securities in certain circumstances, for some it is a big no, they suggest selling the securities instead of taking a loan. “It’s always better to liquidate investments instead of taking a loan, especially in the current scenario where markets are down, recession looks to be around the corner, you may have job insecurity and so on," said Taresh Bhatia, a Sebi-registered investment adviser, and partner at Advantage Financial Planners LLP.
Bhatia added that one can take a loan against gold or property, as a last resort. These assets come with high transaction cost, and therefore liquidating them may not make sense. In fact, taking a loan against property may be the best option as you can keep using the asset even when there is a mortgage against it. “Loan against property is the best option because it is available at the lowest interest rate compared to other avenues," said Manoj Pandey, director, Mainstream Investments Advisors Pvt. Ltd, a Delhi-based financial planning and wealth management firm.
It is important to choose the asset carefully and clear it as soon as possible, added Pandey.
The overall decision should be based on the amount and tenure of loan you want to take, the returns that the securities are giving, the penalty and charges involved in case of redemption or surrender and your repaying capability.