Emergency Funds: Should you take loan or redeem your investment; What is a more feasible option?

51-year-old Ajay Singh is in urgent need of money to pay for his daughter's short-term course at an overseas university that she wants to pursue in the forthcoming summer vacation. Although he has access to money but most of his wealth is locked in the securities and mutual funds.

Now he is facing a dilemma: should he redeem some of the investment or raise a loan to pay for his daughter's trip?

He is not keen to the idea of redeeming his investments because of two key reasons. One, most of his investments are trading lower than the price he bought them for. And second, it could disrupt his long-term financial plan. And alternatively, if he opts for the option of raising loan, he would end up paying a high rate of interest.

ALSO READ: Need urgent cash? You can raise loan against mutual funds. Details here

What should he do? We asked some experts, and they give a multi-pronged solution to this. First and foremost, they suggest that one can use his emergency corpus. The second alternative is to redeem some of the debt instruments. And finally, one can raise loan so long as the rate of interest is lower than the average returns one expects to earn from current investments.

Use emergency funds

Experts recommend that one should use emergency corpus in case of an urgency. The emergency corpus may include a blend of overnight funds, liquid funds, money market funds and fixed deposits (FDs).

“If it is a planned need such as for down payment of a car or a house or a college admission expense or a planned medical procedure, then one should plan in advance and move their risky portfolio to low-risk investments such as liquid funds or even fixed deposits. At the time of the requirement, it is better to redeem and not borrow. If the need is unexpected such as a medical emergency or a job loss and less than your emergency corpus, then redeem from your emergency corpus,” said Neelabh Sanyal, COO, Kuvera.in.

He further adds that one can raise loan when the requirement of money surpasses the emergency corpus.

“If the emergency needs exceed the emergency corpus, then you can consider a loan though after evaluating tax implications of a redemption, if any, the period of requirement and the applicable loan rate,” he added.

While expressing similar views, Preeti Zende, a Sebi-registered investment advisor and co-founder of Apna Dhan Financial Services, says: “The first thing one should plan for is to have an adequate emergency fund. This emergency fund not only covers your six months’ monthly expenses and EMIs but a monthly component of your annualized expenses as well. I should also have some room to face any unforeseen situation where lumpsum money can be required. You can keep a 25 percent cushion for the same.”

When to raise loan?

The experts, however, believe that raising a loan can be preferable over redeeming investments in certain cases. This can prevent investors from disrupting their financial goals.

“If someone is in dire need of cash, they should refrain from redeeming their investments. There are two ways to raise loan: first is to take a personal loan for which interest rates are very high i.e., 12 to 18 percent. So, this option is not very advisable. But if one already holds mutual funds, they can take loan by keeping them as collateral to meet urgent requirement. In that case, the rate of interest one has to pay is 9-10 percent,” says Sridharan Sundaram, Co-founder of Wealth Ladder Direct.

“This is how, they can save interest in the range of 2-7 percent. Besides this, equity markets offer long term returns to the tune of 12 percent, which is more than the interest one would pay on loan borrowed. So, taking loan on mutual funds is beneficial from interest saving perspective and return perspective,” he adds.

Preeti Zende, too, says that other options of raising loans can be explored when you fall short of funds.

“If you do not have adequate funds, in that case, you need to look for other options such as loans or liquidating the assets. Selecting the option depends on the individual's financial situation. If the need for funds is small then one can opt for a loan of a shorter period without having to disrupt the long-term financial plans. But if your long-term investments are not yielding returns then it is better to use the securities in such situations. One needs to take a call where the cost and damage to the financial situation are minimal,” she advises.

In conclusion, the emergency financial needs can, and should, be met with emergency fund which entails cash as well as debt securities.

Alternatively, one can raise loan against mutual funds so long as the rate of interest is lower than the expected returns of investments. And the last resort could be to redeem investments when the money requirement outpaces emergency fund.