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What are loans against securities?

Loans against securities are one of the many financial products derived by the finance industry to help investors achieve their goals without having to move around their assets very much.

In this article, we’re going to learn about loans against securities and how they play a pivotal role in facilitating liquidity while minimising risks for both borrowers and lenders.

Introduction to loans against securities

Loans against securities, commonly known as LAS, refer to a financial arrangement where borrowers pledge their securities such as stocks, mutual funds, bonds, or insurance policies as collateral to obtain a loan from a financial institution.

This form of credit is given by the institution in return for the securities that are pledged as collateral. Usually, the sanctioned loan amount is less than the intrinsic value of the securities. This is done to ensure that in case of default, the financial institution can get their money back by liquidating the assets at market price.

This amount is usually valued through a ratio called the loan-to-value or LTV, which is the ratio of the sanctioned loan amount and the value of the underlying security collateral.

LTV = Sanctioned loan amount / Value of the underlying securities

Key steps in acquiring a loan against your securities

The process of obtaining a loan against securities typically involves the following steps:

  1. Collateral evaluation: Lenders assess the value and quality of the securities that you have offered as collateral to determine the loan amount. This loan amount, as aforementioned, is usually a percentage of the intrinsic value of these securities.
  2. Disbursement of loan: Upon approval, the lender disburses the loan amount for a specific purpose – whether that’s a personal loan, education loan, etc.
  3. Interest and repayment: You repay the loan amount along with accrued interest within a specified period, failing which the lender may liquidate your collateral to recover the dues.

There are several players usually involved in such transactions:

  • Banks: These are institutions that have established robust loans against securities offerings, leveraging their extensive branch networks and financial resources to provide convenient and well-regulated services. Banks, due to their size and heavy regulatory requirements, are more stringent in regulation and compliance compared to other lenders.
  • NBFCs: These have also emerged as significant players in the securities market space. They usually offer more flexible and customised solutions to meet the specific requirements of their clients.
  • Fintech platforms: These new-age companies have introduced innovative solutions for loans against securities, streamlining the application process and enhancing accessibility.

Why get a loan against your securities?

You must be wondering why you would pledge your securities for a loan that you would get otherwise too, and you’d be asking a valid question. Here are some reasons why:

  • Liquidity enhancement: LAS enables you to unlock the value of their securities without selling them. This means that you not only get cash to spend while being invested in the market, you also participate in the capital gain upside.
  • Flexible terms: Borrowers enjoy flexibility in terms of loan amount, tenure, and interest rates, tailored to their specific financial needs when they put up securities for collateral.
  • Quick processing: Compared to traditional loans, LAS offers faster processing times also.
  • Lower interest rates: With securities serving as collateral, lenders take on less risk by lending you money which often translates into lower interest rates.
  • Entrepreneurial financing: Entrepreneurs and small business owners have also embraced loans against securities. These products help them fund their ventures, expand operations, or meet short-term cash flow needs without sacrificing their long-term investment strategies.

Regulations for acquiring a loan against securities

There are certain guidelines that are already in place that govern loans issued against securities.

For NBFCs, for instance, the RBI restricts the maximum loan amount granted against physical securities to ₹10 lakh and ₹20 lakh for dematerialized securities held electronically.

The RBI also mandates a maximum LTV for loans exceeding ₹5 lakh. This LTV is typically lower for equity shares (around 50%) compared to debt instruments (up to 75%).

You can read more about the specific regulations around this product on this RBI website.

Frequently Asked Questions

What types of securities can be used as collateral?

Most commonly, securities for loans include publicly traded stock, mutual fund units, bonds and debentures, ETFs, NPS holdings, and sovereign gold bonds.

What are the tax implications for these loans?

If you’re using the loan for personal purposes, the interest paid on the loan is eligible for tax deduction under Section 24 of the Income Tax Act. There are no tax implications on the securities used as collateral. However, when used for business, the securities used as collateral may have capital gains tax implications if they are sold or redeemed.

What happens if the value of the pledged securities drops significantly?

In the event of a significant decline in the market value of the securities pledged as collateral, the lender may issue a “margin call” to the borrower. A margin call is a request for the borrower to add more collateral or repay a portion of the loan to maintain the required LTV ratio.

Can a borrower switch the securities used as collateral during the loan tenure?

Yes, in some cases, borrowers may be able to switch the securities used as collateral during the tenure of the loan. This is known as “collateral substitution” and is subject to the lender’s approval and the fulfilment of certain conditions:

Can a borrower take out multiple loans against the same securities?

Yes, it is possible for a borrower to take out multiple loans against the same securities, subject to the lender’s approval and adherence to the regulatory guidelines. This is known as “cross-collateralization” or “multiple pledging.”

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