Investment borrowing, i.e., a loan against security, is becoming an increasingly feasible option for investors to raise funds without relinquishing their investments. Financial institutions and banks lend you money if you own shares, mutual funds, bonds, or insurance policies by keeping these as collateral.
This security loan facility doesn’t jeopardize your long-term wealth accumulation plan. However, apart from having numerous advantages, there are some borrowers who commit some unnecessary faults that will eventually catch up with them in the long run. The following are the worst borrowing on security mistakes to make.
Lack of knowledge regarding how a security loan works
A security loan allows you to borrow against your money funds as collateral, but without their entering your physical possession. They can be:
- Equity shares
- Mutual fund units
- Government bonds
- Exchange Traded Funds (ETFs)
- Life insurance policies
- Sovereign gold bonds (SGBs)
The lenders take a portion of the market value of such securities at present, the Loan-to-Value (LTV) ratio is allotted as the size. You hold and are remunerated interest on the collateral securities, but cannot redeem them or offload them until you settle the loan.
1: Overlooking market risks
Market fluctuations will be the largest risk in a loan on security. You take shares of equity or mutual funds on loan, and they depreciate due to the market having shifted, your lender will invoke a margin and require you to:
- Deposit additional securities
- Repay part of the outstanding loan
- Deposit more on your margin in an interval
Margin call might lead to involuntary sale of your collateral at poor prices. Keep a watch on the quality and level of market risk of your collateral at all times.
2: Overspending beyond what you require
While it is generally fine to borrow the full amount available (about 50%–80% of asset value), this does not give you much cushion. If the value of the security falls a bit, you’ll be stuck with a margin call.
Borrow no more than you require to finance your actual financial requirements so that you’ll have some cushion against value declines.
3: Failure to mention the loan-to-value (LTV) limit
Different securities carry different LTV ratios. Some examples are:
- Equity shares: 50%
- Debt mutual funds: 70%
- Sovereign bonds: 75%
Don’t hope that all your investments will sit together and collectively agree on the same loan quantum. Determine how much you can borrow as a loan and how much you can repay through a loan against securities EMI calculator. Without it, you could be left with a mismatch between the expectation and actual sanction of a loan.
4: Oversight of interest rates
Interest rates on loans against security vary with the financier and are charged based on the security taken as collateral. Loans against debt mutual funds or liquid funds would be cheaper than loans against equity shares.
Example:
- Loan against debt mutual funds: 8.5%–10% pa
- Loan against equity shares: 10%–12.5% pa
- Loan against insurance policy: 9%–10% pa.
Always check the interest rate, prepayment charges, and processing charges while choosing the lender. The long-term cost will be determined by a loan against securities EMI calculator.
5: Not accounting for the pre-closure and overdraft charges
Few security loans are overdraft facilities in which you pay interest on borrowed money alone. Few are term loans with fixed EMIs.
Interest on overdrafts is charged on a daily basis and recovered monthly.
Prepayment charges can be levied on term loans if they are repaid prematurely.
Omitting these sections at the beginning can lead to surprise charges or rigidity. Read the repayment plan and terms and conditions attentively prior to signing a contract.
6: Collateralizing volatile shares
All prospective collateral stocks are not equal. Most lenders will maintain a pre-approved list of their favorite stocks. Very volatile, poor-quality, or illiquid stocks will be rejected outright or taken at a lower margin.
Acceptance, however, aside, volatile stocks can cause margin call risk. To avoid that, pledge diversified mutual funds or government securities instead for safe lending.
7: Not making your securities lien-marked
Once you pledge assets, they remain in lien with your lender. That is:
- They cannot be redeemed by you until the loan repayment.
- Corporate action (bonus, dividend, split) can be relayed through the lender.
You may need to monitor variable asset value more closely.
This is what the lenders forget and try to sell or use the pledged securities, which is not desirable.
8: Missing due date
Payment on time is crucial, especially if you have taken a term loan with EMIs for periodic repayment. It can cause:
- Delay payment charges
- Negative effect on your credit score
- Sale of securities pledged
Use standing payment orders, and glance through your repayment calendar at regular intervals.
9: Not determining the cost of borrowing
A few of the borrowers care only about interest rates and not fees, such as:
- Processing charge
- Pledge preparation cost
- Stamp duty
- Account maintenance or renewal charges
Collectively, if they can estimate the cost of borrowing approximately. The loan against securities EMI calculator is highly likely to be the best way of estimating the cost in total and making plans accordingly.
10: Taking a loan to invest in speculative schemes
Investing the proceeds of the loan, speculating to buy securities, short selling shares, or even investing in cryptocurrencies would be a level of financial risk. If your investments in the new venture do not yield profits and your collateral securities also decline, you’d be issued a margin call as well as repayment tension.
Be careful while using the loan proceeds for working capital, illness, or unforeseen expenditure. Never indulge in splurging borrowed funds as investment funds unless you are well acquainted with the risk involved.
Conclusion
A loan on security gives you instant access to funds without compelling you to sell your investment. You have to take it in anticipation and a sense of finance. Don’t fall into the said follies so that you make maximum use of this facility without losing your investments.
Before availing the advantage, contrast the best offers offered by certain lenders, find out what margins and liens are needed, and estimate with a loan against securities EMI calculator so that smart decisions can be taken. Lend intelligently, pay punctually, and meet your long-term financial goals.