InvestmentS in financial assets such as mutual funds, equity shares, etc., become a source of liquidity in case of emergencies such as unexpected medical needs and unforeseen expenses. However, selling such assets which are meant for long-term financial needs is not a good idea. Instead, one could possibly consider taking a loan against those securities. Let us discuss in detail, when one should go for such type of loans and the associated pros and cons in detail.
To manage urgent needs
At times, we need money to meet expenses for a medical emergency, major repair to a vehicle, etc. Arranging funds with a short notice is a difficult task. In such a scenario, instead of liquidating financial assets and exhausting savings one could think of getting instant funds by availing a loan against securities.
Lower rate of interest
Generally, loans against securities have a lower interest rate than most of the unsecured loans and credit cards. This is because borrowers are pledging their shares as collateral and thus the rate of interest is lower. Such types of loans are typically offered as an overdraft facility in the borrowers’ account after they have deposited their securities. The advantage is that you can draw money from the account as and when required and need to pay interest only on the loan amount being used and for the period of usage.
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The amount of loan you are eligible for depends on the value of the securities offered as collateral and bankers compute the loan value as between 50% and 90% of underlying collateral value. For instance, a lender may offer 50% for equity shares and 90% for bank deposits, insurance policy surrender value, etc. This can vary according to the source (banks/NFCs) from where you avail the loan.
Ease of processing
For availing loan against securities, income proof or credit score of the borrower does not come into picture. As it is a secured loan, the banker/ lender defines the interest rate, tenure, and other specifications purely based on the type of financial asset and its value. This simplifies the loan approval process. In addition, such types of loans are disbursed in 24/48 hours. This will help you out to meet your emergency cash requirements.
Portfolio remains unaffected
By availing loans against securities, the portfolio remains the same. For instance, if you pledge mutual funds, the number of units remain invested in the market, equity shares remain the same and you can avail all the benefits of your investments. Whether it is a dividend from equity shares or an interest income from a bond, the lender has no authority over these payments. You can continue receiving gains from the investments as long as there is no default on repayments. In other words, in this type of loans, you can continue to avail the returns and dividends though they are kept as a collateral.
Drawbacks associated
Though there are many advantages of availing loans against securities, there are also certain drawbacks. Generally, banks and FIs offer a low loan to value ratio which is not favourable for those who have low-priced stocks. Further, if the investor wanted to sell the shares and book profit at an appropriate time, he cannot sell the same. In case the portfolio value decreases significantly, the lender can lower the loan against shares’ maximum limit and ask the borrower to repay some amount from the principal.
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In other words, one cannot gain full authority and control over the portfolio until the repayment of loan. Such type of loans are not suitable for home loans and lenders will not accept all companies’ shares as they have their own list of shares and only those shares they will consider.
To conclude, availing loan against security in case of emergency helps investors to stay invested. One should look at the situation and act accordingly keeping in mind the above parameters.
The writer is a professor of finance & accounting at IIM Tiruchirappalli