Can I Use a Mutual Fund As Collateral?

A mutual fund is an arrangement between investors who pool their money and hire a professional money manager to invest it. Mutual funds typically invest shareholders' money in stocks and bonds, and occasionally in precious metals, commodities, real estate interests, futures contracts and many other types of financial assets. Usually, you can use a mutual fund as a collateral for a loan, if you can find a willing lender. However, there are some important exceptions.

Margin Borrowing

The most common arrangement in which investors use mutual funds as collateral to secure a loan is in margin borrowing. Margin borrowing describes the process of borrowing money from a stockbroker by using financial assets in the customer's brokerage account as collateral for the loan. The account balance of the collateral does not fall, but if the customer doesn't repay the loan, the brokerage company will sell shares to make up the loss.

Margin Calls

Under 2011 regulations, margin borrowers cannot borrow more than they have on deposit with the brokerage firm. If the assets in the account fall in value, the brokerage company issues a margin call, asking borrowers to make up the difference. Borrowers have a limited amount of time to either pay off the loan or deposit additional cash into the account. If they do neither, the brokerage firm will share their holdings -- whether stocks, mutual funds, bonds or any other type of asset -- to bring the loan-to-collateral ratio back within regulatory guidelines.

Exceptions

Typically, you cannot use a mutual fund in an Individual Retirement Account as security for a loan, whether it is a margin loan through your broker or a nonmargin loan with an outside lender. If you attempt to do so, the IRS can disallow your IRA and strip the account of its IRA status. This deprives the IRA of many of its tax advantages, including tax deferral, and results in a taxable distribution. The IRS may levy income tax on the entire amount in addition to a 10 percent penalty if you are under age 59 1/2.

Considerations

Borrowing against your mutual fund holdings can make sense if it helps you diversify your assets and potentially increase your overall returns. It can also make sense for short-term expenditures if you want to avoid paying capital gains taxes on shares sold at a profit. However, borrowing -- also called "leverage" -- can potentially magnify any potential losses as well. If you borrow money against any financial investment, it is possible to lose more money than you had originally invested. This is because when your account value falls, your debt does not fall with it. For example, if you have $100,000 in mutual funds in a brokerage account, and you borrow $50,000 against it, and your brokerage account loses 50 percent, your debt doesn't fall by 50 percent along with it. You still owe the full $50,000.