The number of people who took loans against shares at the end of September 2015 shrank to 26% y/y in India, as opposed to the 43% growth recorded at the same time in 2014, according to an article in DNA. The reason cited by the article is the current volatility of the equity markets. However, it is important to note that there are several advantages of a loan against securities as opposed to its alternatives. As long as the loan seeker holds sufficient eligible shares to pledge as collateral, he can reap the benefits of easy access and lower interest rates. It is due to the lack of risk-taking ability or adequate information that most people are unable to capitalize on their investments. The Reserve Bank of India’s guidelines state that only non-banking financial companies (NBFCs) with assets of more than Rs 100 crore can offer such financing.
How do Such Loans Function?
There are several NBFCs that offer largely two types of loans against securities:
- Loan against Shares (LAS): This is a type of term loan against marketable securities for a fixed period of time. It can be obtained by pledging one’s shares to the NBFC by way of a lien.
- Line Of Credit (LOC): This allows a person to take an overdraft against their marketable shares and pay interest only on the actual time period during which the funds are utilized.
The NBFC considers financing requests after seeking a lien on the shares in its name. The funding is offered depending on the value of units held in the applicant’s folio. The amount of money that can be accessed as loan against shares depends on the type of investment. The Reserve Bank of India guidelines state that a loan to value (LTV) ratio of 50% must be maintained. However, there is usually a minimum and maximum loan amount that is set by the lender. Once the amount is repaid, the company lifts the lien and the applicant regains rightful ownership of the shares.
Advantages of Loans against Securities
There are several advantages of this type of financing, as opposed to the more traditional alternatives, such as:
- No Need to Sell Your Stocks: This the primary advantage of this option. Instead of selling your shares in a bullish market, where the value of equity is set to rise, you could simply take a loan against the shares and make the most of your investments.
- Immediate Liquidity: If your shares have been scrutinized and found to be eligible for the loan, you can receive funding with a minimum waiting period. There is no need for a guarantor for such financing, as opposed to other loans of higher value. As such, this is much easier to obtain as opposed to other forms of loans.
- Lower Interest Rates: The interest rate is typically lower than that for personal loans. Moreover, in the case of a Line of Credit, one only pays interest for the actual time period in which the funds are utilized.
- Bonuses and Dividends Retained: You can continue to enjoy the returns of the shares that you pledge as collateral during the tenure of the loan. This allows you to truly take advantage of a rising market as you are not only able to avail a high value loan, you are also able to retain the dividends from your investments.
- Possibility of Renewal: These corporate loans are eligible for renewal, typically on an annual basis, as per the discretion of the lender.
- Defaulting on the Loan: In case there is default, the NBFC can invoke the lien and redeem the units for repayment. This is a better option than a transferable loan or any other type of high risk financing, since the penalty for defaulting is not as harsh as in other cases.
5 Things to Keep in Mind When Opting for a Loan against Shares
- Not all shares are eligible: You need to contact the NBFC for their list of eligible shares before you proceed to applying for a loan with them.
- Do Not Borrow to Invest in Other Shares: Taking a loan to buy shares is not only a harmful financial habit, it is also forbidden by many lenders.
- Charges Applicable: There are many charges, such as processing fees, one-time fee, renewal charges, government levies and service taxes, that one should be aware of before going in for a loan against shares.
- Rules of Pre-payment: Usually there is no penalty for prepaying. However, it is best to check the terms defined by the specific NBFC.
Revaluation of Shares: It is important to keep in mind that shares that act as collateral for the loan are valued every week. When the value of the portfolio falls, the NBFC may ask you to pay the difference using cash or by pledging more shares.