However, leveraging equities comes with conditions and risks that should be carefully considered.
How borrowing against shares works
A loan against shares (LAS) allows borrowers to pledge their shareholding as collateral for an overdraft facility, offering flexibility by only charging interest on the amount used.
For example, if shares are worth ₹10 lakh has been pledged, which the borrower can access ₹5 lakh, following the Reserve Bank of India’s (RBI) maximum loan-to-value (LTV) ratio of 50%. However, lenders may apply stricter limits. For mid-cap and small-cap stocks, the LTV can drop to 30%.
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The RBI mandates that the LTV ratio for LAS should be limited to 50%. If the value of the pledged shares declines, causing the LTV to exceed this threshold, borrowers have two options:
- Reduce the loan amount to restore the LTV to 50%.
- Pledge additional shares to increase equity coverage.
For example, if a borrower uses the full amount ₹5 lakh overdraft against shares initially worth ₹10 lakh, and the share value drops to ₹8 lakh, the LTV crosses the 50% mark. To recover it, the borrower must reduce the loan amount to ₹4 lakh or promise another ₹2 lakh worth of shares to maintain coverage. The revaluation of the LTV takes place daily.
The LTV ratio varies depending on the quality of the pledged shares. “A range of loan-to-value ratios are offered by different lenders. For large-cap stocks, the borrower can typically get the highest loan-to-value ratio allowed, which is 50%. For small and mid-cap stocks, this can drop to as low as 30%,” explains Ravi Doshi, head of corporate lending at Mirae Asset Financial Services (India).
Mirae Asset maintains a base LTV of 45% to maintain an additional buffer, which is further adjusted based on inventory quality. While the RBI’s 50% is the upper limit, lenders can impose stricter restrictions to limit risks.
It is important to note that not all stocks are eligible for LAS. Each lender maintains a list of approved shares, and only shares on this list can be pledged as collateral.
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Repayment schedule
Equity loans typically have a term of one year, with some lenders offering the option to roll over the loan for certain fees. Unlike traditional loans, LAS does not require monthly EMI payments that combine principal and interest. Instead, borrowers only have to pay the outstanding interest each month.
For example if you borrow ₹5 lakh at an annual interest rate of 10%, the daily interest rate would be around 0.03%, which translates to a monthly interest rate of 0.85%. This means that your monthly interest payment would be approx ₹4,246.
Once the principal is fully repaid, the pledged shares are released and interest no longer accrues.
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Because LAS acts as an overdraft facility, interest is only charged on the amount used, offering borrowers additional flexibility. Most lenders charge interest rates between 9-12%.
Can you lose your shares?
Yes, there are scenarios where you risk losing your shares if certain conditions are not met:
Failure to restore the LTV ratio within seven days: If the Loan-to-Value (LTV) ratio exceeds 50% (or the lender-specified threshold) and is not restored within a seven-day period, the lender may seize and sell your shares to to recover the overdue amount.
For example, let’s say the pledged shares are initially valued at ₹10 lakh drop to ₹8 lakh, reducing the eligible loan limit to ₹4 lakhs. If the borrower has already drawn ₹5 lakh, the excess ₹1 lakh is late. If the borrower fails to reduce the loan or pledge more shares within seven days, the lender can sell the shares worth the loan ₹1 lakh to meet the shortfall.
Immediate liquidation for higher LTV violations: If the LTV reaches 60% or higher, the lender can liquidate the shares immediately, without waiting for the seven-day grace period.
Non-payment of interest: Lenders can also sell the pledged shares if the borrower does not pay interest for 60-90 days from the due date, depending on the loan conditions offered by the lender.
When to use
In the event of emergencies or unexpected expenses, a share loan can be a useful option.
“We have seen customers using it for medical emergencies, or even to take out other expensive loans,” says Vinayak Savanur, a Sebi-registered investment advisor at Sukhanidhi Investment Advisors.
He shared an example of a customer who swapped a high-interest personal loan with LAS, benefiting from lower interest rates and greater repayment flexibility.
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Although LAS offers flexibility in borrowing and repaying at low interest rates, it remains a liability. It should only be used if there is a real financial need as there is always a risk of losing your shares. Borrowers should be careful to ensure they only take what is needed for a short term, keeping the loan to value ratio well within the limits set by the lender.
