Loan Against Mutual Funds or Personal Loan: Which is Better?

Loans from banks and financial institutions are a lifeline for unexpected expenses or medical emergencies. Life’s surprises and challenges often catch us off guard, leaving us unprepared for financial demands. Fortunately, there are different types of loans available, whether you have assets to mortgage or not. Understanding the options for loans against mutual funds and personal loans revolves around whether you have an asset to mortgage or not. 

In this blog, we will delve into the variances, benefits and limitations of loans against mutual funds and personal loans. We aim to provide you with the information necessary to make a well-informed decision regarding borrowing. Let us begin this exploration!

Usual Challenges Faced When Immediate Cash Crunch Arises

Facing an immediate cash crunch can be incredibly stressful, especially when essential expenses need to be covered. Some common challenges people encounter during these times include - 

• Prioritizing expenses: To prioritize expenses, it is important to focus on essential costs such as rent, utilities, food and medicine. This might require cutting back on discretionary spending, which can be challenging when living paycheck to paycheck. 
• Food insecurity: Many people struggle to afford nutritious food, leading them to rely on food banks or affordable yet less healthy options. This can result in a lack of essential nutrients and overall decreased well-being. Finding affordable and healthy food options can be a significant challenge for many individuals and families, contributing to the issue of food insecurity. 
• Debt burden: Cash shortages can pose challenges in fulfilling debt payments, which may result in late fees and negative impacts on your credit score. 
• Anxiety and emotional strain: Financial pressure can have a significant impact on your mental health, leading to anxiety, stress and emotional strain. It is important to find healthy coping mechanisms and seek support when dealing with financial difficulties to protect your mental well-being. 
• Difficult financial decisions: Having to navigate difficult financial decisions can be challenging. It may involve contemplating options such as selling belongings, borrowing money or postponing important bills, each of which can have lasting effects. 
• Impact on relationships: Financial strain is known to have a significant impact on relationships, often resulting in increased tension and conflict. This strain can affect relationships with partners, family members and even close friends. The added pressure can lead to disagreements and stress, ultimately straining these connections. 
• Limited access to credit: It can make it challenging for people experiencing financial constraints to secure traditional loans, thereby making it difficult to meet their immediate financial needs. 
• Feeling ashamed or embarrassed: Financial difficulties can often carry a burden of shame or embarrassment. This stigma can make it more challenging to reach out for support, whether from loved ones or financial institutions. 

What is a Loan Against Mutual Fund and How Does It Work?

Loan Against Mutual Funds (LAMF) is a way to leverage your mutual fund units and access funds through an overdraft facility. Banks, financial institutions and NBFCs like Investkraft’s streamlined LAMF application process allow you to digitally lien mark your funds and access the necessary funds. 

The loan operates as an overdraft facility, permitting convenient access to necessary funds and the flexibility to repay at any time without incurring extra fees. Interest is solely applied to the amount utilized and for the duration, the loan is utilized. 

Example of LAMF

Anjali, a software engineer in Bangalore, had built up a substantial amount in her mutual fund investments. When faced with a sudden medical emergency in her family, rather than liquidating her mutual fund investment, she chose to take out a loan backed by her mutual fund holdings instead. 

Anjali approached her bank, where her savings account and mutual funds were in demat form. The bank assessed her mutual fund portfolio, valued at 10 lakh rupees, and determined that Anjali could borrow 6 lakh rupees based on a 60% LTV. The bank offered her a 10% annual interest rate for the loan, which was much lower compared to a personal loan. 

Anjali’s loan application was approved quickly and the funds were transferred to her account within 3 days. This allowed her to handle her emergency without affecting her investment strategy. As a result, her mutual fund value continued to appreciate. 

What is a Personal Loan and How Does It Work?

Personal loans are a type of instalment credit. In contrast to a credit card, a personal loan provides borrowers with a lump sum of cash. Subsequently, borrowers repay the borrowed amount along with interest through regular monthly instalments over the loan duration, commonly referred to as its term. 

After approval, a personal loan typically goes directly into your checking account, providing you with immediate access to funds. In certain cases, if the purpose of the loan is to refinance existing debt, you may be able to ask the lender to make payments directly on your behalf. 

Once you receive your funds, make sure to start making repayments within 30 days. With a fixed-rate loan, your monthly payments will remain constant until the loan is completely repaid. However, with a variable-rate loan, the interest may vary, resulting in changes to the amount owed each month. 

Once your personal loan is fully repaid, the associated credit line will be terminated, resulting in a loss of access to it.

A Side-by-Side Comparison of Personal Loans and Loan Against Mutual Funds (LAMF)

Choosing between a personal loan and a Loan Against Mutual Funds (LAMF) depends on your specific financial situation and needs. Here's a detailed breakdown to help you decide: 

Particular	Loan Against Mutual Fund	Personal Loan
Loan Type	You can obtain a secured loan by using your existing mutual fund units as collateral. This means you can borrow a certain amount of money from a lender with your mutual fund units serving as a guarantee for the loan	It is an unsecured loan that is not backed by collateral. Instead, the lender determines the loan amount and interest rate based on the borrower’s creditworthiness, which includes factors such as income and credit score
Interest Rate	Usually have lower interest rates because they are backed by collateral, in this case, mutual fund units. This reduces the lender’s risk, leading to more favourable terms for the borrowers	Higher interest rates are often a result of inadequate collateral and can differ based on your creditworthiness
Loan Amount	The loan amount is typically a percentage of the Net Asset Value or NAV of your mutual funds. However, it is important to note that the NAV may be lower than what you require at the moment	The option of a higher loan amount would be beneficial for covering substantial expenses such as home renovations or major purchases. This flexibility can provide more financial support during times of significant financial need
Repayment	You have the option to benefit from a more customizable repayment plan, where you can choose to pay only the interest each month and have the flexibility to repay the principal amount at your convenience, resulting in lower EMIs. Additionally, you can make prepayments without incurring extra charges	EMIs are a popular repayment method that combines both the principal and the interest into fixed monthly instalments
Impact on Investment	If the market value of your mutual fund investments drops significantly and falls below the loan amount, there is a risk of a margin call. In such a situation, your mutual funds may be sold to repay the debt	No impact on investments.
Processing Time	Applications typically take longer to process than personal loan applications due to the larger amounts of money involved and the need for thorough asset assessments	You can usually expect quicker processing times and reduced paperwork when using this method

 

How to Decide If I Need a LAMF or a Personal Loan?

When considering a loan against a mutual fund (LAMF) vs a personal loan, it is important to weigh the pros and cons of each option. You should - 

Go for LAMF if:

• You currently have mutual fund investments and are in search of a lower interest rate
• You can manage potentially lower loan amounts and market fluctuations
• You simply require a short-term loan, which you can conveniently repay at a later date

Go for a Personal Loan if:

• You do not have mutual funds or you do not wish to use them as collateral
• You require a larger loan amount for a specific purpose
• Your good credit score makes you eligible for a lower interest rate
• You value the predictability that comes with making fixed monthly repayments

Conclusion

Unexpected financial emergencies can cause major disruptions to your budget, but personal loans and loans against mutual funds (LAMFs) can offer much-needed support. To make the best decision, it is important to carefully assess your financial circumstances and requirements. 

Considering the advantages and disadvantages of LAMFs and personal loans is crucial for making a well-informed decision that aligns with your financial circumstances and provides support during challenging moments.

Frequently Asked Questions (FAQs)

Q1: What happens if the value of my mutual fund holdings falls?

A: LAMFs provide a level of security by using the value of your mutual fund holdings as collateral. However, if the value of your holdings decreases substantially, you may be required to either deposit more cash or sell some units to keep the required loan-to-value ratio in check.

Q2: What are the processing fees and other charges associated with LAMFs?

A: When considering LAMFs, it's important to take into account potential processing fees, foreclosure charges for not meeting margin calls, and even annual maintenance charges. These additional costs should be factored in when comparing the overall cost of a LAMF to that of a personal loan.

Q3: Are there any alternatives to LAMFs and personal loans?

A: You should carefully assess your options before getting a loan. It is worth exploring alternatives such as securing a line of credit with your mutual funds or negotiating a payment plan with your creditors. These options could help you avoid the need to take out a loan.

Q4: How can I ensure I'm making the best decision between a LAMF and a personal loan?

A: Consider creating a detailed budget and examining your current financial situation to determine how much you can realistically afford to borrow. Take into account factors such as interest rates, loan terms, and potential tax implications before making a decision. Seeking advice from a financial advisor who can offer tailored recommendations based on your individual circumstances can be valuable in helping you make an informed choice.

Q5: What if I need emergency funds and have both a LAMF and a personal loan option?

A: Personal loans are faster than LAMFs if you need cash urgently. But if you can wait a few days and the LAMF has a lower interest rate, it might still be worth considering.

Q6: Is there a way to combine the benefits of a LAMF and a personal loan?

A: Consider using a combination of a LAMF and a personal loan to cover your funding needs. This strategy can help you benefit from lower interest rates while ensuring you have enough funding. However, make sure to plan carefully and assess your ability to manage repayments for both loans.