You need Rs 5 lacs to fund an important event in your family. You have 2 options.
- Sell your debt funds (you had built up an emergency fund using debt funds for such situations only)
- Take a personal loan
Selling your debt funds seems a superior decision over taking a personal loan. Why?
Because the post-tax returns from your debt funds are unlikely to beat the cost of a personal loan. Therefore, you are better off selling your debt MF investments than taking a personal loan. However, there is friction when you sell debt mutual funds. That friction is in the form of taxes. Can this affect your choice? Let’s see how to think about this problem.
How Are Debt Mutual Funds Taxed?
If your sell your debt fund units before completion of 3 years, the resulting capital gains shall be considered short term capital gains (STCG). STCG on debt funds is taxed at your marginal tax rate (tax bracket).
If you sell after completion of 3 years, the resulting gains shall be considered long term capital gains and will be taxed at 20% after indexation.
If you are in 30% or higher income tax brackets, you would find tax regime is kind to long term capital gains. Hence, you would want your capital gains to be taxed as long term gains rather than as short term gains.
How Does Taxation Affect Your Choice?
If you sell your debt funds to fund your requirement, you will have to pay some taxes too. And that needs to be considered. Let’s say you need Rs 5 lacs for your requirement. You had invested Rs 5 lacs 2 years. Now, the value has grown at 6% p.a. to Rs 5.62 lacs.
| Original Investment | 500,000 | We are only considering short term capital gains example. If the gains are long term, selling debt funds will likely be a better decision | ||||
| Years (Holding period in years) | 2 | |||||
| Tax Rate (Short term) | 30% | |||||
Purchase NAV (Assumed) | Return | Current NAV | Current Value | Money needed | Taxes to be paid | Net Amount spent / Redemption Amount |
| 500 | 6% | 561.80 | 561,800 | 500,000 | 17,064 | 517,064 |
| 500 | 6.5% | 567.11 | 567,113 | 500,000 | 18,405 | 518,405 |
| 500 | 7% | 572.45 | 572,450 | 500,000 | 19,733 | 519,733 |
| 500 | 7.5% | 577.81 | 577,813 | 500,000 | 21,051 | 521,051 |
| 500 | 8% | 583.20 | 583,200 | 500,000 | 22,356 | 522,356 |
| 500 | 9% | 594.05 | 594,050 | 500,000 | 24,932 | 524,932 |
As you can see, to fund your requirement, you must sell more than Rs 5 lacs. That extra amount is because of taxes and that’s additional cost. The quantum of taxes will depend on your net returns, marginal tax rate and the holding period. In the table above, I have considered a marginal tax rate of 30%. Lower the tax rate, the less you pay in taxes (and redeeming debt fund units get more attractive option).
I focus only on the short-term gains (holding period of less than 3 years) because if the units are long term, the tax regime becomes quite benign (you pay 20% after indexation on Long term capital gains). If the gains are long term, selling long term units will likely be a better option than taking a personal loan.
Now, contrast with the net amounts you will have to pay if you were to go for a personal loan.
| Loan Amount | Interest Rate | Tenure (months) | EMI | Net Amount spent |
| 500000 | 12% | 3 | 170,011 | 510,033 |
| 500000 | 12% | 6 | 86,274 | 517,645 |
| 500000 | 12% | 9 | 58,370 | 525,332 |
| 500000 | 12% | 12 | 44,424 | 533,093 |
| 500000 | 12% | 18 | 30,491 | 548,838 |
| 500000 | 12% | 24 | 23,537 | 564,882 |
| 500000 | 12% | 36 | 16,607 | 597,858 |
You can see that the amounts are not too different, especially for shorter loan durations. You can calculate net obligations for your requirement. And choose where you have to pay less tax.
Point to Note
The debt fund units will eventually be sold. And such sale will result in capital gains tax liability. You might ask, if the taxes eventually have to be paid, why not pay them now? Why bear unnecessary cost of personal loan when taxes can’t be avoided? Valid point. And that’s why selling long term units in debt funds is a better choice than taking a personal loan because you don’t save anything by NOT selling long term debt fund units. Whenever you sell, you will have to pay LTCG tax. Why not pay it now? The only saving is in the form of time value of money. But that is nowhere close to the cost of personal loan.
What about short-term units? By NOT selling short term units, you are trying to convert short term units to long term units. And pay lower tax.
While the units are short-term, you pay 30% tax (marginal rate) on capital gains. If you belong to the high income group, your marginal tax rate can go as high as 42.7% due to cess and surcharge.
When the units become long term, you pay 20% after indexation on capital gains. The net tax rate could be 15%, 10%, 5% or even negative. Depends on the levels of Cost-of-inflation-index (CII) announced by the Government of India.
If you opt for a personal loan in place of selling debt MF units, your analysis must support that the tax savinga (from letting short term units become long term units) is greater than the interest cost of personal loan.
For a complete analysis, I should have considered the net impact of converting short term units to long term units (and not just taxes on the short-term units). I leave it to you to build on this analysis.
Personal Loans Have Friction Too
Personal loans also have friction. Apart from the interest cost, there will be a processing fee that increases the effective cost of borrowing and your net obligation.
Then, there is a prepayment penalty that reduces your flexibility. In absence of any prepayment penalty, you would pay off the high-cost loan as soon as you have the cash available.
Your Cashflow Position
A personal loan would require repayment and your cashflows must support such repayment. If you know upfront that your cashflows can’t support loan repayment, do not complicate matters. Just sell the debt fund investments.
Why? Because eventually you will have to. To pay personal loan EMIs. Why complicate matters?
The choice between the personal loan and the sale of debt fund units must be considered only when your cashflows are strong enough to support loan repayments.
Note that in all the examples discussed in this post, there may be corner cases where the action I suggest may not be the most optimal mathematically. Not possible to cover all possible scenarios. Hence, for your requirement, do the math and use your judgement.
An Overdraft Facility against Your Debt Funds May Be the Best Solution
If your loan requirement is for a short term, a secured overdraft facility could be a good solution. Instead of selling your debt funds, you take an overdraft facility against those funds. Since there is no sale, there is no capital gains tax liability. Besides, an overdraft is a revolving facility. You can prepay whenever you want. No flexibility issues as in case of a personal loan. Moreover, a secured facility against debt funds (or bank fixed deposit) may reduce the overdraft interest rate too. The only thing to watch out for is the processing fee, which can increase the overall cost of the transaction.