Sure, you think you have a million-dollar business idea, but are you willing to bet your house on it? Many entrepreneurs are taking out a home equity loan to finance their startup endeavors.
In most cases, a home equity loan is easier to obtain than a traditional business loan, especially for small businesses just starting without established banking relationships or credit history. But, bankrolling your business this way is an extremely risky proposition. If you fail or experience a bump in the road, you can potentially lose your business and your house.
The Benefits of Using a Home Equity Loan to Finance Your Startup
While there is no denying the risks that come along with this financing approach, there can be great benefits. First and foremost, this may be the only option you have to get the money you need to make the business of your dreams a reality. Getting a business loan can be a difficult process, especially if you don't have business experience or a good personal credit history. Growing an established business that doesn't have a lot of collateral (like investments in costly equipment or real estate) might also be an impossibility without this financing method. The simple fact that home equity loans exist as an option for those who don't meet traditional lending qualifications is a good thing.
Home equity loan interest rates are usually comparably low, and terms may be more flexible than those of a traditional business loan. "Home equity loans (HELs) and home equity lines of credit (HELOCs) typically have low interest rates. HELs usually have fixed rates, currently around 5-7 percent. HELOCs usually start with rates of 3-4 percent, but they are usually variable and can increase over time," said Priyanka Prakash, a finance specialist at Fit Small Business, an educational site for small business owners and entrepreneurs. "With a HELOC, you can draw money as needed to fund your business, which is very convenient if your startup's financing needs change as it grows. You'll be charged interest only on funds that you withdraw and use (HELs are like a traditional loan with fixed monthly payments)." Additionally, since it is a mortgage, interest paid is tax deductible.
Finally, home equity loans are relatively quick and easy to obtain. If your business needs an infusion of cash immediately, you might not have time to work through the lengthy processes involved in traditional business lending.
The Downside of Using a Home Equity Loan to Finance Your Startup
No one wants to be broke and homeless, but that is a real possibility when you use a home equity loan to finance your startup. According to Prakash, "The biggest obvious risk of a HEL or HELOC is that the lender can foreclose your home if you fail to make payments on time. That could potentially be a very scary situation."
While using a home equity loan does open up doors for many small business owners, it isn't an option for everyone. As a rule of thumb, you must have at least 20 percent equity in your home to be eligible for a home equity loan. You must also prove to the bank that your business' income will cover the cost of the monthly payments on the loan.
Home equity loans usually have a lot of fees – from application fees to appraisal fees to title search fees and more. If you don't read the fine print, these fees and other penalties might come as a surprise. Prakash advised, "There are already so many costs that go into a startup, so you should try to find a lender who will minimize fees for you."
Changing interest rates might also come as an unwelcome surprise if you use a HELOC to finance your business. "Since a HELOC usually has a variable rate, your interest rate can increase. HELOCs typically have a 5- to 10-year draw period followed by a 10- to 20-year repayment period. During the draw period, you can withdraw funds and pay interest only. During the repayment period, your monthly payments increase because you have to pay principal and interest. Many borrowers aren't prepared for this transition," said Prakash.
So, is it a good idea to finance your startup with a home equity loan? That depends on your personal tolerance for risk. The stakes are tremendously high, but you just might hit the jackpot!