Nothing prevents you from using a mutual fund for collateral, providing your lender will accept it. There are reasons, however, why the lender may not. There are also some procedural complications in providing a mutual fund as security for a loan that make it a less-than-ideal form of collateral.
Lenders Don't Like Equities for Collateral
At the retail level, lenders like collateral that can easily be seized, such as real estate. Your bank is set up to do that, and it doesn't require extra effort. As Bank of America points out, asset-based clients are generally "middle-market-and-larger companies" with long-term capital needs and annual revenues of $10 million to $1 billion. Your local banker may discourage you from applying for an asset-based loan using a mutual fund as collateral for several reasons: It necessitates an appraisal that can't be outsourced; your banker may lack the expertise and authority to make the appraisal herself; the volatility of a single mutual fund represents a relatively high, undiversified risk; and drawing up papers giving your bank undisputed title in the event of your default may require the participation of the lender's legal department at added expense.
Handing Over the Certificate
If your lender is willing to make you a loan with your mutual fund as collateral, it will almost always require both physical access to the mutual fund certificate and the right to sell the fund and recover their money in the event of your default. If the mutual fund shares are already in your possession, the first part -- giving the bank possession -- is easy. If the shares are in your brokerage account, it's very likely there is no physical certificate, and you will have to ask your broker to provide you with one, which the brokerage will normally obtain from the mutual fund's management. By federal regulation, the management has seven days to provide the certificate.
Title in the Event of Default
You may want to discuss with your banker how it wants to obtain the right to sell the fund and recover the proceeds if you default. It may want its legal department to draw up papers giving them that right. Alternatively, if the loan is large enough, it may allow you to keep the mutual fund in a separate brokerage account titled "Your name for the benefit of your bank," and to sign papers giving it the right to liquidate the mutual fund and to receive its share of the proceeds. These agreements generally apply to larger loans. Once you set up a "for the benefit of" account, your rights with respect to the mutual fund may be limited. You may need the bank's written permission, for example, to sell that fund and buy another fund.
Consider Buying a CD
An alternative may be simply to sell the mutual fund and purchase a certificate of deposit from the lender. As a Bankrate article points out, lenders are used to lending money with CDs as collateral and will generally give you a relatively low loan rate -- probably two to three points over the CD rate.
I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.