Understanding Loans Against Shares: A Comprehensive Guide
When investors face urgent cash requirements but wish to avoid selling their equity holdings, a loan against shares (LAS) emerges as a viable financial solution. This facility allows individuals to borrow funds from banks or non-banking financial companies (NBFCs) by using their shares as collateral. However, navigating the specific rules and market risks associated with this type of credit requires careful attention and understanding.
The Process of Obtaining a Loan Against Shares
The journey to secure a loan against shares begins with completing a one-time Know Your Customer (KYC) process with the lender. This typically involves providing your PAN and Aadhaar details. If your Aadhaar is linked to your mobile number, the required information can be fetched automatically through DigiLocker, streamlining the verification process.
Once KYC is completed, shares are pledged using the depository participant (DP) ID. The DP then sends a confirmation once the pledge is successfully created. It is important to note that pledging shares is permitted only on working days, so timing your application accordingly is crucial.
By pledging your shares, you can avail an overdraft facility from the lender. Your bank account will be verified online through an e-mandate, after which you must read and digitally sign the loan agreement to finalize the process.
Determining Your Loan Amount and LTV Ratios
An overdraft facility is a flexible line of credit that allows borrowers to withdraw funds up to a pre-approved limit. Interest is charged only on the amount actually used and for the period it remains outstanding. According to Reserve Bank of India (RBI) rules, the maximum loan-to-value (LTV) ratio is set at 50%.
For example, if you pledge shares worth ₹8 lakh, you can obtain a loan of up to ₹4 lakh. If the lender offers the maximum permissible LTV ratio of 50%, the largest loan you can secure is ₹1 crore, which requires pledging shares worth ₹2 crore.
"Banks can offer up to ₹1 crore as a loan against shares to an individual, while non-banking financial companies have no such limit," explained Kapil Nagpal, a member of the founding team of Volt Money.
It is essential to understand that LTV ratios vary depending on the quality of the shares pledged. "Loan-to-value ratios vary across lenders. Large-cap stocks usually qualify for the maximum permissible LTV of 50%. For small- and mid-cap stocks, it could go down to as low as 30%," said Ravi Doshi, business head-secured loans at Mirae Asset Financial Services (India).
Mirae Asset Financial Services, for instance, maintains a base LTV of 45% to build in an extra margin of safety, with further adjustments based on stock quality. Although the RBI allows an LTV of up to 50%, lenders may set lower limits to manage risk effectively. Additionally, not all stocks are eligible for a loan against shares, as lenders maintain their own approved lists of stocks that can be pledged as collateral.
Managing Risks When Share Values Drop
If the prices of your pledged stocks decline, it can push the LTV ratio beyond the 50% threshold. For instance, if you have an outstanding loan of ₹4 lakh against ₹8 lakh worth of shares and the share value drops to ₹7 lakh, the LTV ratio climbs to 57%. To restore it to 50%, you have two options:
- Reduce the loan amount by paying ₹50,000 to bring the outstanding value down to ₹3.5 lakh
- Pledge additional shares worth ₹1 lakh to restore the equity cover to ₹8 lakh
This LTV revaluation is conducted daily. "For small investors with limited holdings, this can become cumbersome, particularly during volatile market phases, as sharp price swings can frequently push the LTV close to or beyond prescribed thresholds," noted Vinayak Savanur, a Sebi-registered investment advisor and founder of Sukhanidhi Investment Advisors.
Repayment Terms and Interest Structure
A loan against shares is typically sanctioned for one year, with some lenders allowing it to be rolled over for a fee. Unlike conventional loans, it does not involve EMIs that combine principal and interest. Instead, borrowers are required to service only the interest each month.
For example, if you draw ₹4 lakh at an annual interest rate of 10%, the daily interest works out to about 0.03%, or roughly 0.85% for the month. This translates to a monthly interest payment of around ₹3,400. Once the principal is fully repaid, the pledged shares are released, and no further interest accrues. Most lenders charge interest rates ranging from 9% to 12%.
Potential Risks of Losing Your Shares
Yes, there are situations where you can lose your pledged shares. If the loan-to-value ratio breaches the permitted limit—50% or a lower threshold set by the lender—and the shortfall is not corrected within the stipulated deadline, the lender can sell the pledged shares to recover the outstanding amount.
For instance, if pledged shares initially valued at ₹8 lakh drop to ₹7 lakh, reducing the eligible loan limit to ₹3.5 lakh from ₹4 lakh, and the borrower has already drawn ₹4 lakh, the excess ₹50,000 becomes overdue. If the borrower fails to reduce the loan or pledge more shares within seven days, the lender can sell shares worth ₹50,000 to cover the shortfall.
If the LTV touches 60% or higher, the lender can liquidate the shares immediately without waiting seven days. Lenders can also liquidate pledged shares if the borrower defaults on interest payments for 60 to 90 days, depending on the loan's terms and conditions.
Should You Consider a Loan Against Shares?
Financial planners generally advise that loans against shares are suitable for short-term requirements. "We typically advise clients to use this for short-term needs, especially when the requirement is for less than a year. In such cases, a loan against shares can be a practical alternative to selling equities, which would otherwise trigger capital gains tax and break the long-term compounding benefit of staying invested in stocks," said Surya Bhatia, a financial adviser at Asset Managers.
"However, it is not advisable as a long-term solution. Equities can go through bouts of volatility, even when the portfolio is largely tilted towards large-cap stocks. Extending an LAS for longer periods also means that interest costs steadily eat into overall equity returns," he added.
Use this option sparingly and only for short-term loans. Avoid utilizing the maximum LTV, as it can lead to frequent margin calls during volatile markets, requiring you to pledge more shares or reduce the loan outstanding to prevent losing your shares.
