Share Pledging: How can shares in a demat account be used as collateral for a loan?

Are you holding shares or mutual fund units for your long-term financial goals? During a financial emergency, instead of selling a part of your investment, pledge it and take a loan against it. Pledging of shares/mutual fund units for a loan has benefits over selling them. Let us understand what is pledging, the process, and its benefits over selling the investments.

What is share pledging?

Pledging is the process of committing shares held by an individual in favour of another person/organisation as a security. The person holding the shares is known as the pledgor. The person in whose favour the shares are pledged is known as the pledgee.

For example, Ishita holds 100 TCS shares. She wants to take a Rs. 1 lakh loan against the TCS shares from HDFC Bank. In this case, Ishita is the pledgor, and HDFC Bank is the pledgee, wherein Ishita is offering TCS shares as security/collateral to HDFC Bank to take a loan against the shares.

Once you pledge the shares in favour of the bank/NBFC and complete the remaining loan formalities, the loan amount will be approved.

How much loan can you get?

It is important to note that you will not get 100% of the value of shares or mutual fund units as the loan amount. For shares and equity mutual fund units, financial institutions can give a loan of up to 50% of the value of the securities pledged. Equity shares and equity mutual funds are volatile in the short term and vulnerable to big falls. Hence, the financial institution may keep a margin of safety of 50% to protect itself from the fall in the security price.

For debt mutual fund units, you may get a loan of up to 80% of the value of the securities pledged. As debt securities and debt mutual funds are relatively more stable than equities, the financial institution keeps a lower margin of safety than equities. Hence, you can get a bigger loan by pledging these securities as collateral.

Every bank/NBFC has a minimum and maximum loan amount offered under the "loan against securities (LAS)" product. Check the various fees involved like processing fee, stamp duty, annual renewal charges, interest rate, etc.

How does the loan repayment happen?

The loan is offered in the form of an overdraft. You will have a specified credit limit from which you can withdraw the money. The interest is charged only on the amount used. For example, Ishita takes a loan of Rs. 1 lakh. She will be charged interest every month on the amount utilised and for the number of days utilised. The partial or full repayment can be made at any time without any penalty.

As a loan against shares/mutual fund units is a secured loan, the interest rate charged on it is lower than unsecured loans like personal loans. The tenure of the loan is one year. It can be renewed every year.

How to create and remove a pledge?

You (pledgor) will have to initiate a pledge by raising a request with your Depository Participant (DP). Once the DP processes the request, the lender (pledgee) must confirm it. On confirmation, the pledge will be created. The shares/mutual fund units offered as security will be blocked. The pledgor cannot sell them until the pledge is removed.

On the loan repayment, the pledgor will have to initiate a request to close the pledge with its DP. The request will be forwarded to the pledgee. The pledge has to confirm the pledge closure request. Alternatively, the pledgee can close the pledge request directly even before the pledgor initiates the closure request. Once the pledge is closed, the block on the shares will be removed. The pledgor is then free to deal with the securities as they wish, including selling them if required

Sometimes, a pledgor may want to change the securities/mutual fund units offered as security. For example, Ishita, who has provided TCS shares as security to HDFC Bank, may want to change the securities collateral to Reliance Industries shares. The change of securities offered in a pledge is possible, if the pledgor allows. In that case, a new pledge will have to be initiated for Reliance Industries shares, and the pledge for TCS shares will have to be closed.

What is the benefit of pledging shares?

When you pledge shares in favour of the financial institution, you continue to remain the owner. You will get all the corporate benefits from the company like dividends, bonus shares, etc. You can exercise your voting rights and will also benefit from the rise in the share price.

Some financial institutions like Mirae Asset Financial Services have built a 100% digital process for loans against shares. The borrower can complete the entire process and get the loan amount on the same day. No need to visit the branch for physical form filling and submitting documents.

What happens if the borrower is unable to repay the loan?

If the pledgor is unable to repay the loan, the financial institution can sell the shares and recover the loan amount. Hence, it makes sense for the borrower to repay the loan to retain the shares offered as collateral.

Pledging shares is a win-win for both parties. The pledgor continues to own the shares and get corporate benefits. The pledgee gets a security for the money lent.

Use share pledging to your advantage

In a financial emergency, instead of selling your shares, use them as collateral to take a loan against them. You can do that by pledging them with a financial institution. You will get a loan at competitive interest rates. The interest has to be paid only on the amount utilised. You will continue to own the share and will get the corporate benefits. Thus, you can make the most of your shares by pledging them for a loan during financial emergencies.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.