Investment in mutual funds is one of the common ways of wealth generation in India. But under liquidity crisis, borrowers take advantage of borrowing against mutual fund units to fulfill short-term requirements without divesting their holding. Taxation implications of borrowing against mutual fund need to be taken into account as it decides whether borrowing against mutual funds will be an effective financial decision or not.
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What is a loan on mutual fund
Loan against mutual fund is a facility through which investors can pledge units of their mutual fund and make use of funds without actually selling the units. Banks and NBFCs provide this facility primarily. The investor’s units are not disbursed but retained in his/her name and given the tag of being pledged until the loan is redeemed.
Loan size is commonly a proportion of the market value of mutual fund units. The facility keeps the investment portfolio absolute and addresses the liquidity needs. The interest costs on these loans are competitive and lower than credit cards and personal loans. For this reason, many investors consider a loan on mutual fund as a more cost-effective option compared to other short-term borrowings.
How loan against mutual funds interest rate is calculated
Interest rate on loan against mutual funds varies based on a number of variables:
Lender policies
NBFCs and banks charge differential interest rates considering risk perception.
LTV ratio
70-85% of the market value of MF units is lent by lenders in the form of loan. The interest will be more with higher LTV.
Type of mutual fund
Debt and equity funds have varied volatility and liquidity characteristics and hence influence interest rate.
Borrower creditworthiness
The borrower’s credit history and credit report also determine the rate of interest at the end.
The interest rates on mutual fund loans in India are typically 9% to 14% per annum, which is lower compared to that of unsecured loans. It is always best to shop around the terms and conditions before utilizing this facility.
Tax implications on loan against mutual funds in India
One of the strengths of borrowing against units in a mutual fund is its tax-relief treatment. The next paragraph is a detailed discussion of the tax issues.
Proceeds of loan are exempt from income tax
The funds collected against loan, whether against other securities or mutual fund, are not taxable income according to the Income Tax Department. As you are receiving money as loan and not earning the same as income, no tax is levied while availing the loan.
No tax on capital gains if mutual fund units are not sold
When you borrow against your mutual fund units, transfer or redemption of units is undertaken. Therefore, no capital gain event takes place. Capital gain tax is imposed only at the time of transfer or redemption of mutual fund units. Therefore, a loan against a mutual fund maintains the tax effectiveness of the investment.
The interest on the loan cannot be claimed as a tax-deductible expense for tax purposes in most situations
Contrary to some home loans or business loans, interest on loan from mutual fund is typically not considered an allowance for consumption. However, a loan can be allowed interest allowance under section 37(1) of the Income Tax Act, where it is taken to carry on a business or to earn taxable income. For personal consumption, interest charge cannot be claimed as deduction from income.
Tax on release of pledge or mandatory redemption
At the time of default, dues can be repaid by the lender by selling pledge units. Redemption is taxed as capital gains at rates applicable based on the duration for which units are owned:
- Short-term capital gains (STCG): When units are owned for a term less than 12 months, STCG is taxable at 15%.
- Long-term capital gains (LTCG): If units are held for over 12 months, income of over Rs. 1 lakh in a year is charged at 10% without indexation.
The risk cannot be strange to investors as forced redemption directly impacts post-tax yield and capital.
Advantages of taking a loan against mutual funds
- Liquidity without units sale: Your holding is not requested for redemption, and therefore investments are not disrupted.
- Tax efficiency: There is no capital gains tax on loans in case of units being under pledge.
- Lower interest rates: Interest rates of such loans are less than unsecured loans.
- Funds access upfront: Process is normally quicker, taking advantage of underlying mutual fund investments.
- Minimize market timing risk: Market timing of units for redemption is eschewed, which is negative.
Key points to note while availing loan against mutual fund
- Interest rates: Mutual funds interest rate should be compared with loan and other loan schemes to determine cost-effectiveness.
- Repayment period: Should be aware of the repayment duration so that defaults can be avoided.
- Portfolio effect: Pledged units cannot be transferred or sold by the borrower without prior approval of the lender during the loan tenure.
- Loan-to-value ratio: Borrowing almost at market value subjects one to larger margin calls.
- Tax goals and personal financial planning: Ensure that the loan aligns with your investment strategy.
How to avail a loan against mutual fund in India
Investors can approach banks or NBFCs offering loans against mutual fund security. The process is as follows:
- Units to be pledged: Choose units with sufficient market value.
- Application and KYC documents: Submit proof of identity, proof of address, and proof of mutual fund holding.
- LTV valuation and sanction: Financier values the market and approves the loan amount.
- Execution of loan agreements and pledge forms: Formal paperwork is executed.
- Deposit of funds in borrower’s account: Loan is credited, typically within days.
Certain websites have also allowed simple digital pledging, making it even quicker.
Comparison with other sources of finance
- Personal loan: Unsecured but pay higher interest rates and with more eligible criteria.
- Loan against shares: Similar to loan against mutual funds but only on share holdings.
- Credit cards and overdraft: For very short-term requirements but at a premium cost.
Loan against mutual fund is helpful to investors who require moderate-interest borrowing as per their increasing investments.
General myths regarding loan against mutual funds rate of interest and taxation
- There will be no instant tax liability for borrowing over mutual funds.
- The loan against mutual funds interest rate should be similar to that of unsecured loans.
- Such interest on loans cannot be recovered in case of tax-deductible income.
- Loans never affect NAV (Net Asset Value) of your mutual funds; redemption is the only exception.
Conclusion
Borrowing against units of mutual funds provides you liquidity without disrupting your investment portfolio and with tax-favored status. The proceeds from the loan are not taxable, nor is the capital gains tax invoked unless on default of the loan you redeem units. While interest on loan against mutual funds is extremely low, you must analyze the whole financial situation thoroughly.
For Indian investors, knowledge of such tax ramifications and cost considerations makes you well-informed strategic decision-makers for the benefit of short-term money requirements as well as long-term wealth accumulation. Always seek advice from a financial planner for personal advice prior to availing a loan over mutual funds. This information makes you competent to leverage your mutual fund investment to your benefit without losing tax benefits.