Should You Choose Equity or Debt Funds?

These days, investments in mutual funds are growing very fast. However, if the investor faces financial emergencies, such as fees for children’s education, medical expenses, or needs capital for a business, in these situations, for many, it seems like there is no other option than selling the mutual funds. Selling the mutual funds will shatter the long term goals, or may have to sell in the markets which are unfavorable. 

This is where LAMF (Loan Against Mutual Funds) comes into play. An investor can borrow funds by pledging their Mutual funds, even without selling them. But here comes the question: does it matter to pledge Equity or Debt Mutual funds? The answer is Yes; it does matter. This article gives you insights into both Equity and Debt Mutual Funds.

Understanding Loan Against Mutual Funds:

LAMF is a secured loan. LAMF is a loan provided by lenders (Banks or NBFCs) against Mutual Fund units. Rather than redeeming the investments, a lien is placed on your Mutual Fund is given to the lender. Also, Mutual funds continue to generate revenue.

• Key Features:
  • Investments can be retained rather than redeeming.
  • Lower rate of interest compared to unsecured loans.
  • Fast processing
  • Less documentation
  • Flexibility during repayment

Equity vs Mutual Funds:

• Equity Mutual Funds: In Equity funds, funds are primarily invested in the stocks of the companies. It has high potential to earn good returns, and it also has high volatility, which makes the investment highly risky. It is suitable for long-term investors.
• Debt Mutual Funds: Debt fund investments are mostly made in fixed-income securities such as bonds and government securities. These investments earn fixed returns, and it has low volatility. So, the risk is also low. It is suitable for short-term investors.

Loan-to-Value (LTV): How Much Can You Borrow?

• Equity Mutual Funds: The LTV of Equity Mutual Funds is up to 50% which means the lender lends up to 50% of the value of the mutual funds. Since the volatility is high, the lender will lend a smaller amount, so they have less risk exposed.
• Debt Mutual Funds: The LTV of Debt Mutual Funds is up to 80%, which means the lender offers 80% of the value of the Mutual Fund. As the investment in Debt Mutual Funds is less risky, the lender can offer higher amounts.

For Example: If the value of a Mutual Fund is 10,00,000, then

• If it is an Equity Mutual Fund, you can get a loan up to INR 5,00,000.
• If it is a Debt Mutual Fund, you can get a loan up to INR 8,00,000.

Also read: Getting a Home Loan? Watch Out for These Hidden Costs That Could Drain Your Wallet!

Interest Rates:

• Equity Mutual Fund: As the risk is high in Equity funds, the interest charged is also high. The interest charged ranges from 11% to 13%
• Debt Mutual Funds: As these funds do not possess high risk, the interest charged is also lower. The interest rate charged would range from 9% to 10.5%

Risk involved:

• Equity Mutual Funds: Equity funds possess a high risk of margin calls because they are dependent on NAV. Due to high volatility, NAV may drop, so the eligible amount also reduces. For e.g- The value of the Mutual Fund is 10,00,000, and LTV is 45%, the Eligible amount is 450,000 (LTV is 45%).
• If the NAV drops and the value becomes 800,000, then the effective LTV becomes 56%. At this, the lender will demand either to bring in more collateral or to repay the portion of the loan. If no action is taken by the borrower, then the lender would liquidate the mutual funds.
• Debt Mutual Funds: In the case of Debt Mutual funds, the potential returns generated are less compared to Equity Mutual Funds. Sometimes, the revenue generated from these mutual funds would be less than the interest rate charged on LAMF.

When to Choose Which for LAMF:

• Equity Mutual Fund:
  • If you don’t want to disturb your long-term planning and wealth creation.
  • Make quick repayments.
  • Comfortable and prepared to manage margin calls
  • You just require a small portion of your investment.
• Debt Mutual Funds:
  • You require a higher portion of your investment. 
  • You require funds for the short term.
  • You want lower interest rates.

Comparison Table

Conclusion

To conclude this, it is always the ultimate choice of the borrower to decide what type of fund is suitable, based on the preferences and risk-taking capacity. For LAMF, Debt mutual funds are to be preferred, as they have high LTV, less interest and the risk of margin calls. On the other hand, equity funds have high risk and low LTV, but they offer higher returns. Considering LAMF, Debt Mutual Funds is good to prefer.  

Written by N G Sai Rohith