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If you are looking at raising money against your assets or investments, a loan against a fixed deposit (FD) will be a better option than borrowing against other assets.

“Consider a situation where the borrower is unable to repay the loan for some unforeseen problems. If the loan involves a home that is mortgaged with the bank, the borrower can lose it. The same holds for other assets," said Arnav Pandya, founder of Moneyeduschool, an Ahmedabad-based financial literacy initiative.

Taking a loan is more cost-effective than paying a penalty by withdrawing FD, especially when the borrower can prepay
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Taking a loan is more cost-effective than paying a penalty by withdrawing FD, especially when the borrower can prepay

If the borrower defaults on a loan against FD, the bank will deduct the principal, interest and penalties, and pay the remaining funds to the depositor on maturity. Some banks may even offer additional time to the borrower to repay. There are other reasons why a loan against FD is preferable to borrowing against other assets. Let’s look at them:

WHAT TO CHOOSE WHEN

There are multiple options when you are looking at raising funds against an asset. A borrower can take a loan against gold, stocks and mutual funds. Gold loans are, typically, for a shorter tenure. In the case of loans against securities, the loan-to-value (LTV) ratio, or the amount offered against securities’ market value, is 50%.

If you need a loan for a longer tenure and higher LTV, better options are a loan against FD, a top-up home loan, and a loan against property (LAP). “Choosing between the three comes down to three things—the collateral, interest rate and the tenor," said Adhil Shetty, chief executive officer, Bankbazaar.com, an online marketplace for financial products.

Consider a situation where an individual requires a 5 lakh loan. While all three options are equally viable, they have caveats. Loan against FDs could be the least expensive. With FD rates averaging around 5.5%, a borrower can get a loan for as low as 6-6.5%.

Typically, banks offer it 50 to 250 basis points (bps) above the FD rate against which the borrower is taking the loan. “The only caveat is that banks lend at 90% of the FD value. If the loan requirement is 5 lakh, the borrower should have an FD of around 5.6 lakh with the bank," said Shetty.

The borrower must repay before the maturity of the FD—it cannot exceed the tenure of the FD.

A top-up loan is straightforward. The borrower needs to have a home loan running with a good repayment track record. The total balance outstanding after the top-up needs to be within the same LTV ratio at which the lender had issued the loan.

Top-up rates are at par with home loan rates. You also get a long tenure for repayment. Moreover, if borrowers take it for repairs or refurbishings, they get a tax benefit.

LAP, too, comes with a long tenure. Depending on the ultimate use of the money, the borrower may be able to claim tax benefits. Suppose an individual is using the money for business purposes. In that case, the borrower can claim the interest paid and the incidental costs such as processing fee and documentation charges as business expenditure under Section 37(1) of the Income-Tax Act. The interest rate on loan against property, however, is higher compared to the other two options.

OD VersuS LOAN AGAINST FD

You can borrow against FD in two ways—take a loan or ask the bank to issue an overdraft (OD).

“In an overdraft, banks sanction a credit limit based on the amount of FD submitted as collateral. The borrower can withdraw up to the sanctioned amount and repay based on his repayment capacity. The interest is charged only on the amount of money utilized," said Sahil Arora, director, Paisabazaar.com. The loan against an FD works similar to any other loan. The bank makes the funds available to the depositor, and he must repay the loan in equated monthly instalments, or EMIs. There is no fixed duration for repayment of an overdraft. The borrower needs to pay the interest for as long as he holds the money.

WHEN TO LIQUIDATE AN FD

Taking a loan against FD works better than liquidating it when the funds required is lower than the money parked in the FD.

Say you have an FD of 5 lakh but need only 2-3 lakh. A loan would be a better option. “There is a premature penalty on the withdrawal of FD. In many cases, a loan would be more cost-effective than paying the penalty, especially when the borrower can prepay it," said Arora.

But if you don’t have clarity on whether you would repay on time, it’s better to break the FD. “If a borrower defaults on the loan against FD, his credit score will get impacted," said Pandya.

It’s best to avoid borrowing unless there’s no other option available. If the situation forces you to take a loan, evaluate the best option based on the interest rate, tenure and the mortgaged asset.

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