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What Happens When Your Loan Against Mutual Funds Goes Into Default

What happens if I can't repay my Loan Against Mutual Funds (LAMF)?

Will my mutual funds be sold the moment I miss an interest payment?

What if I don't respond to a margin call in time?

Will my lender inform me before redeeming my mutual funds?

Under what circumstances can they sell them? And will they redeem my entire portfolio or only a part of it?

If you've had any of these questions, you're not alone. There are several misconceptions around what happens when a Loan Against Mutual Funds goes into default. Let's separate the myths from the facts and understand what happens.

How You End Up in Default

Default on a Loan Against Mutual Funds usually happens when the loan remains unresolved despite the lender's reminders or required actions.

This can happen in two common situations.

Missed Repayments: When the borrower fails to meet repayment obligations. Since a Loan Against Mutual Funds works as an overdraft facility, this means not paying the interest due on the amount you've withdrawn. Or failure in repaying the principal amount on maturity.

Margin Call: Other is when a borrower doesn't respond to a margin call within the stipulated time.

While the reasons may differ, the lender follows a set of processes that are already highlighted to the borrower in advance. But here is what actually happens once you are in either scenario.

What Your Lender Actually Does When You Default

If you miss repayments or don't respond to a margin call, your lender doesn't immediately sell your investments.

You'll receive reminders and an opportunity to regularize your loan by repaying the overdue amount or, if required, pledging additional eligible mutual fund units. The time available to do so depends on how much the LTV ratio has breached the permitted limit. A smaller breach may give you more time to restore the required margin, while a larger breach may require quicker action.

For example, if your monthly interest payment is missed or bounces, the lender will notify you immediately and inform you of the amount due, along with the stipulated timeline within which the payment must be made. If the payment isn't received within that timeline, the lender may sell or redeem only the number of pledged securities required to recover the overdue amount.

Similarly, if the value of your pledged Mutual Funds falls and your Loan-to-Value (LTV) exceeds the permitted limit, the lender will notify you of the shortfall and the amount required to restore the margin. You'll also be informed of the stipulated timeline to regularise your loan. If the margin isn't restored within the specified period, the lender may sell or redeem only the minimum number of pledged securities required to bring the loan back within the permitted LTV.

In both situations, the objective is to recover only the amount necessary—not to sell your entire investment portfolio.

Since the mutual funds were already pledged as security for the loan, this is a secured loan. So, the recovery process doesn't usually require the lender to obtain a separate court order.

How Much of Your Portfolio Actually Gets Sold

Your lender redeems only as many units as needed to clear your outstanding principal, interest, and charges. It doesn't liquidate your entire pledged holding by default, and if you've pledged across multiple schemes, it typically redeems just enough to cover the shortfall.

For example, if you owe ₹2 lakh and your pledged mutual funds are worth ₹8 lakh, the lender won't redeem the entire ₹8 lakh portfolio. They will redeem only enough units to recover the outstanding dues or restore the loan to the permitted LTV.

If the units redeemed are worth more than what you owe, you get the surplus back.

Do You Owe Tax on Forced Redemption?

Yes. A forced redemption is still a redemption for tax purposes. Capital gains apply exactly as they would if you'd sold the units yourself, and your holding period is counted from your original purchase date, not from the date you pledged them.

So if you pledged equity fund units you'd already held for two years, and your lender redeems them to recover a default, that sale is a long-term capital gains event for you, whether you intended to sell or not.

Suppose the equity units redeemed at ₹6.3 lakh had an original cost of ₹4.5 lakh. That's a gain of ₹1.8 lakh. Since you held the units for over a year, this is a long-term capital gain. Gains above ₹1.25 lakh in a financial year are taxed at 12.5%, so ₹55,000 of that gain is taxable, working out to roughly ₹6,875 in tax, on a sale you didn't choose to make.

The mechanics differ for debt funds. If yours were bought on or after April 1, 2023, your gains are taxed at your income slab rate regardless of how long you held them. It's worth knowing which category your pledged units fall into before your lender decides the timing for you.

Related Blog: How a Loan Against Mutual Funds Can Help You Save on Capital Gains Tax

Does Defaulting Affect Your Credit Score?

It can.

Defaulting on a loan may affect your credit score if the lender reports the account as overdue or in default to the credit bureaus. The impact depends on factors such as how long the dues remain unpaid and the lender's reporting practices.

The longer a loan remains unresolved, the greater the likelihood of it affecting your credit history. That's why it's important to respond to lender communications and resolve the outstanding dues as early as possible.

How to Avoid Getting Here

Default rarely happens overnight. More often, it's the result of small issues that go unaddressed.

If your lender issues a margin call, respond to it as soon as possible. If you're finding it difficult to keep up with repayments, don't ignore the reminders. Reaching out to your lender early may give you more options than waiting for the loan to slip into default.

Staying on top of your repayments and keeping an eye on your pledged investments can go a long way in helping you avoid the recovery process altogether.

What If You Believe Your Mutual Funds Were Wrongfully Redeemed?

If you believe your lender redeemed your pledged mutual fund units without following the terms of the loan agreement or applicable regulations, you don't have to simply accept the decision.

You can:

• Request a detailed statement explaining the redemption and the outstanding dues.
• Raise a written complaint with your lender's Grievance Redressal Officer.
• Escalate the matter through the RBI's Complaint Management System under the Reserve Bank Integrated Ombudsman Scheme if you don't receive a response within 30 days or are not satisfied with the resolution.

Keep copies of your loan agreement, margin call notices, loan statements, emails and SMS alerts. These records can help support your complaint if you dispute the redemption.

Final Thoughts

Defaulting on a loan doesn't always mean losing your entire mutual fund portfolio. But it can trigger a series of consequences, from the redemption of your pledged investments to potential tax implications and an impact on your credit history.

Understanding how the process works helps you make informed decisions and, more importantly, avoid reaching that stage in the first place.

At Mirae Asset Financial Services, you can access funds against your eligible mutual funds through a simple digital process while continuing to stay invested. And if you need assistance, the team is there to help you understand your options before your loan reaches the recovery stage.