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A lot of retail investors take the loan route to participate in IPOs. However, it may not always turn out to be profitable for you.

With the stock markets zooming from strength to strength in the last few months, a lot of companies have been rushing in to tap it. No wonder, initial public offerings (IPOs) are the flavour of the season.

In the week gone by, Reliance Power launched the largest ever IPO to garner over Rs 11,000 crores.

As reports suggest, this offering was oversubscribed within minutes (some have said within 60 seconds) of the opening. And there are indicatons already that the issue is going to be oversubscribed by over 70 times. Even the Future Group IPO, which opened a few days earlier was oversubscribed by over 125 times.

Enthused by such a response, many more companies are expected to enter the market during the current year including Emmar MGF, Mahindra Holidays and Wockhardt Hospitals.

For the retail investor, booming markets always mean great returns. And many would be itching to participate in these IPOs. The banks, on their part, are also doing their bit by encouraging them to invest through either personal loans or 'IPO loans'.

In the former, you can borrow the entire amount and pay annual interest on it. In the latter, the bank would be funding 50 per cent(sometimes up to 80 per cent) of the amount that you wish to invest (the upper limit for retail investors is Rs one lakh) and the rest would have to come from you. The interest rate charged on 'IPO loans' differ from bank to bank.

For instance, Bank of Baroda charges 12.75 per cent annually while some others banks charge 14 per cent and above. Of course, for both personal and IPO loans, there would a processing fee.

However, before investors opt for such loans, they should be looking at the costs that are involved for doing so.

The main cost components in such loans are the interest rate, processing fee and assuming that they prepay the unused portion immediately, a prepayment penalty as well. So let us do some cost-benefit analysis.

Considering that you are taking a personal loan of the entire Rs one lakh at the rate of 16 per cent annum and a processing fee of 2 per cent, the total cost works out to Rs 5,945 for 90 days.

For shorter periods like 21 days, it is Rs 2,921. Since some IPOs like the Reliance Power IPO allows part payments, for smaller amount like Rs 25,000, the total cost is Rs 1,486 for 90 days and Rs 730 for 21 days.

Also, since you would get back the unused portion between 15 to 20 days from the company which we assume will be used immediately to pay back the respective bank there would be an additional prepayment charge of between 1 to 2 per cent.

Given the above considerations, if we were to take the example of an over subscribed IPO such as Reliance Power the share allotment is more likely to be between 10 and 15 shares for every retail investor.

So, taking different scenarios, one can see that the numbers work out fine, if the stock lists at a 100 per cent, 50 per cent or 25 per cent premium. But if it lists at 10 per cent or below, the numbers do not work in the favour of a person who has taken a personal loan to invest.

For the ones who take a lower loan of say, Rs 10,000, the cost of funds for 21 days works out to a mere Rs 292 and the returns would be negative only when the scrip lists at the issue price of Rs 430. Obviously, taking a loan and investing makes sense in some situations.

However, it is important to remember that you returns would be further eroded, if your bank charges a prepayment penalty.

For the retail investor, it is a Catch-22 situation. Most people would like to participate in the IPOs of big companies. And all this hype leads to oversubscriptions, which ultimately means allotment of lesser number of shares.

However if they do not invest, they would lose out on a money making opportunity. Financial experts would always advise that it is better that you do not take any kinds of loans for such investments.

A better idea would be to raise cash by selling off some of your existing stocks. However, if you were to take a loan to invest, do the numbers first. And most importantly, pay back the unused portion of the loan immediately back to the bank. Happy investing!

(With inputs from Suresh Sadagopan, certified financial planner)