Mutual Fund (NFO) Investments on Loan

There is a new investment option coming in to lure the investors in mutual funds – better to say another circus is going to start in the mutual funds investment arena.

Last month, there were as many as 11 different mutual funds launched. All good pretty good response. Banks are now trying to cash in this mutual fund euphoria and earn their income.

Banks have now offered to give special loans exclusively for investments in the new fund offers, or NFO, for Mutual fund investments. People who are not having sufficient money, or they want to invest in the stock market by buying units in the newly launched mutual funds can now avail a loan from these banks. Buy stocks, buy units, buy anything, the bank is there to help you with a loan. No need to have that extra money, just apply for a loan by calling the bank and you will get the money and you can make an investment in the mutual fund of your dreams.

As per the offers, the banks are now willing to fund as much as 80% of the money for investments in mutual funds that will be launched soon through a NFO or new fund offer.
The way it is going to work is as follows:

You have 200,000 or 2 Lakh to invest in a mutual fund that will soon be hitting the stock market. You are certain that the mutual fund will be a good investment in the near or long term future. So you are willing to invest more, say 1 million or 10 lakhs. But the problem is that you have only 2 lakh. Now, you have the option to take a mutual fund loan or a NFO loan as offered by various bank.

As per the conditions, the bank can offer you as high as 80% of the investment value as loan. So if you want to invest 1 million, then all you really need to have is only 2 lakhs, remaining 8 lakhs or 80% will be provided by the bank as a loan.
So, you take the loan, invest the entire 1 million in the NFO and wait for the fabulous returns.

The NFO loan or mutual fund loan that is offered is being charged around 12% rate of interest. Hence, suppose that you take the above mentioned loan at 12%. In 6 months time, your mutual fund investment of 1 million has grown by 20%. Therefore your 1 million is now 1.2 million.

However, you will have to repay the in interest on your mutual fund loan or NFO loan of 8 lakhs. For 6 months, at 12% interest rate, the interest comes to 48,000. So you make a fair amount of profit. You receive 2 lakhs from the 20% increase in your mutual fund investment, you repay 48,000 from that, and hence you keep around 152,000 with you as your profit – fair and square.

But what the catch? Actually there are no catches – directly or indirectly. You must be aware of what you are doing!

In the above calculation, we have not accounted for the entry load charges that may be as high as 3%. Then the exit load charges that may be 1.5%. So your investment of 1 million will reduce to 0.97 million and your 20% assumed return will come down to 194,000. Then, when you exit from this fund, you will pay 1.5% on this 1,194,000 – which comes to around 18,000. Hence, your net return comes down to 176,000. Still a good bet because you will still carry 176,000 – 48,000 = 128,000 as net profit, after paying the interest.

But the biggest problem is with the assumption that the Mutual fund will grow by 20%. What if it falls by 20%??? All the calculations will reverse. Your loan liability will not come down, it will stay as it is, but your returns will not come at all – because you will not be willing to sell your mutual fund invested units for a loss – will you??

And the longer you’ll have to wait for your mutual fund to show profit, the bigger will be the interest that you will have to repay. Hence, the entire risk is bourne by you – the investor and the loan taker.

Why is the bank allowing investors to take this leveraged risk??

Banks are not fools that will simple throw away money to anyone. They come with an offer only if they find it meaningful and profitable. When you take a loan it is your responsibility to repay it. So irrespective of how your mutual fund performs, you will have the liability to repay your loan back.

Now look at some numbers. Banks also act as distribution agents for mutual funds. So when you take a loan for mutual fund investment or NFO loan, the bank will get its distribution charges from the fund house – which can be as little as 4% or as high as 8%.
Even if it is just 4%, then for a 1 million or 10 lakh investment, the bank will pocket 40,000. Also, it will earn interest on the loan amount of 800,000 at 12%. Hence, its effective net return will be 4% from distribution charges + 12% from loan interest amounting to a whooping 16% return (minimum). And most interestingly, the banks returns of minimum 16% are guaranteed. However, the investors returns are “Subject to market risk”.

So think before you leap. Nothing wrong in trading or investing using other people money or a loan amount, but be ready to face the fallouts, which may cause you a major setback. Loan Offers from the banks can be still given a consideration, and so are the mutual funds and the NFO that are expected. All the best!

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