In the world of finance, using your assets to secure loans can be a strategic move. Pledging of shares is one such strategy, allowing investors to unlock the value of their existing stock holdings to meet financial needs. This blog dives deep into the concept of share pledging, its benefits, potential risks, and key considerations for investors.
What is pledging of shares?
Pledging of shares, also known as loan against shares (LAS), is a financial arrangement where an investor uses their shares in a listed company as collateral to secure a loan from a bank or financial institution. The shares are essentially held as security by the lender until the borrower repays the loan amount with interest.
How does pledging work?
- Initiating the Process: The borrower approaches a bank or financial institution offering LAS facilities.
- Valuation and Eligibility: The lender evaluates the borrower's creditworthiness and the value of the shares offered as collateral. Generally, shares of blue-chip companies with high liquidity are preferred.
- Loan Agreement: Upon approval, a loan agreement is signed, outlining the loan amount, interest rate, loan tenure, and margin requirements (percentage of the share value provided as a loan).
- Share Transfer (Dematerialized Accounts): In a dematerialized account, where shares are held electronically, the borrower electronically transfers the pledged shares into the lender's Demat account.
- Safe Custody (Physical Certificates): If the shares are held in physical certificates, they are deposited with the lender in a safe custody arrangement.
- Loan Disbursement: Once the formalities are complete, the lender disburses the loan amount to the borrower.
- Repayment and Release of Shares: Upon full repayment of the loan with interest, the lender releases the pledged shares back to the borrower's Demat account or returns the physical certificates.
Benefits of pledging shares
- Unlocking Capital: Investors can access funds without selling their shares, allowing them to retain potential long-term gains.
- Lower Interest Rates: Compared to personal loans, LAS often comes with lower interest rates due to the presence of collateral.
- Flexibility: Borrowers can typically choose a loan tenure that aligns with their financial goals.
- Maintaining Ownership: Unlike selling shares, pledging allows investors to retain ownership and voting rights associated with the pledged shares (exceptions might exist).
Risks involved
- Margin Calls: If the market value of the pledged shares falls significantly, the lender might issue a margin call, requiring the borrower to deposit additional cash or securities to maintain the loan-to-value (LTV) ratio. Failure to meet the margin call could lead to the forced sale of shares by the lender.
- Market Volatility: Fluctuations in the stock market can impact the value of the pledged shares, potentially triggering margin calls.
- Risk of Default: Loan defaults can lead to the lender selling the pledged shares to recover the outstanding amount. This could result in a loss for the borrower if the share price has fallen.
Key considerations before pledging shares
- Loan-to-Value Ratio (LTV): Understand the maximum LTV offered by the lender. A lower LTV indicates a lower loan amount but reduces the risk of margin calls.
- Interest Rate: Compare LAS interest rates offered by different lenders to secure the best deal.
- Hidden Charges: Be aware of any processing fees or prepayment penalties associated with the loan.
- Investment Horizon: LAS is suitable for short-term financial needs. Ensure the pledged shares are not crucial for your long-term investment goals.
Conclusion
Pledging of shares can be a valuable tool for investors seeking to leverage their existing stock holdings. However, careful consideration of the risks and benefits is essential before entering into such an agreement. By understanding the process, associated risks, and key factors, investors can make informed decisions to utilise pledging of shares effectively in their financial strategies.
