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Using a Home Equity Loan to Finance Your Start-Up
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If you’re an entrepreneur who’s just at the starting line of launching a new business, financing is no doubt at top of your mind. How will this dream venture of yours come to life? For young companies that are too green for a bank to financially get behind, a home equity loan can be an attractive option.
Your home equity happens to be an affordable, accessible source of cash, but using it doesn’t come without risk — if your business fails, your house could end up going down with the ship. Weighing the pros and cons of borrowing against your home to fund a start-up? Here’s a breakdown of everything you need to know before tapping home equity
- What’s a Home Equity Loan?
- Benefits of tapping home equity to start a business
- Risks of betting your home on your business
- Alternative ways to finance a business
- Final thoughts on using your home as collateral
What’s a home equity loan?
A home equity loan (HEL) is exactly what the name implies — a loan that uses your home as collateral and the loan amount is based on how much equity you’ve built up in your home at that point. Equity is the difference between how much you owe on your mortgage and how much your home is worth. So if you owe $200,000 and the home is appraised at $275,000, your equity sits at $75,000. (You can determine your equity here with this easy calculator.)
How much equity you have is reflected in something called your loan-to-value ratio, which usually can’t exceed 85% to qualify. To be eligible for a HEL, you’ll need a healthy credit score, although it is possible to qualify with poor credit. On top of that, your debt-to-income ratio should ideally be no higher than 43%. As for the application process itself, it’s similar to applying for a regular mortgage.
Home equity loan vs. HELOC for start-ups
A home equity line of credit (HELOC) is a close relative to the home equity loan. Instead of a lump-sum loan, however, it works as a revolving credit line. During the “draw period,” you can pull out as much as you like, up to whatever amount you were approved for. This borrowing period, during which you’ll have to make interest payments, typically lasts five to 10 years.
“Home equity loans are probably best suited for small businesses that need to make large, one-time investments upfront,” Amy Jucoski, a North Carolina-based CFP, told LendingTree. She adds that HELOCs, which usually have variable interest rates, are good for those who might need cash flow on demand while their business gets off the ground.
Benefits of tapping home equity to start a business
It can be cost-effective
Borrowing money against your home has one particularly attractive advantage: it may be cheaper than getting a small business loan. Current interest rates on a home equity loan range from 4.25% to 6%, while SBA loans (backed by the Small Business Administration) fall in the 6% to 10% category and can be even more expensive if you’re seeking short-term financing from a private lender.
According to Murray Low, a professor of executive education at Columbia Business School, banks aren’t likely to extend financing to new businesses, but if they do, it probably won’t come cheap. If you’ve created a nest egg of value in your house, it may actually be the most affordable financing within reach.
“If you have the kind of business that doesn’t require outside capital, it can be a terrific source of long-term working capital for an owner-operated business,” he told LendingTree. “In those circumstances, your personal life and your business life are completely intertwined, but you can obtain capital at a rate with a home equity loan that’s just a fraction of what it would cost through any other lending channel.”
Jucoski adds that another reason a home equity loan is attractive is that when borrowing from a hard-money lender, you’ll probably get hit with a 1% to 6% origination fee.
In addition to being a cost-effective source of financing, home equity loans are also wonderfully hands-off when it comes to the actual running of your business. When borrowing from a bank, that lender will likely require a business plan, projections, cash flow statements and the like before considering your application. Not so when applying for a home equity loan or line of credit.
“There’s a lot more red tape that goes into working with a bank to obtain a small business loan,” said Jucoski. “With a home equity loan, the bank doesn’t care about your business because they’ve got your house as collateral, so you don’t have all that oversight.”
Risks of betting your home on your business
You could lose your home
The truth of the matter is that you have to repay a home equity loan or line of credit whether your business succeeds or not. If you end up defaulting on your payments, the bank is within its rights to swoop in and foreclose on your house.
“Banks are much more comfortable betting against your home than your hopeful success,” said Jucoski. “If you get into a situation where you can’t afford to pay back the debt, that’s the risk you take.”
On top of that, the way in which you borrow against your home could also lead to financial strain. While home equity loans come with a fixed rate, home equity lines of credit are typically structured as variable-rate credit. That means that, depending on the market, your rate could go up and down. If money is tight, being on the hook for higher-than-expected monthly payments could make budgeting a little trickier.
Any way you slice it, you have to have some appetite for risk if you make the commitment to gamble your home on your business.
“Oftentimes, new business owners will pour their hearts and souls — and all their available resources, like their home — into the business, living the American dream,” said Jucoski. “And they do this because money isn’t easy to come by when you’re first starting.”
To balance the risk a little, she recommends firming up your financial foundation before seeking this form of financing. In practical terms, this means paying off high-interest debts and building an emergency fund that’s equal to at least one year’s worth of expenses to protect you from future cash-flow issues. She also suggests creating a thorough business plan, even though it isn’t required to secure home equity financing. Doing so will help you better plan for the financial road ahead.
You’re weakening your financial safety net
For many people, their home is their greatest asset — and safety net should financial disaster strike. Whether it’s a stint of unemployment, a health crisis or your child’s college tuition, your house can be a life-saving source of cash in the face of financial uncertainty.
“Once you tie up the equity in your home, that money is no longer available to ‘bail you out’ if you have a significant, unexpected expense,” warned Jucoski.
In other words, if you’re already borrowing against your home to fund your start-up, you may have little borrowing power left over to see you through another curveball life may throw you later on. For those who’ve already tapped their cash reserves, their retirement fund may be the only other asset they can liquidate, but this doesn’t come without a price.
If you’re under 59½, tapping your 401(k) or traditional IRA means paying ordinary income tax on that money, plus getting hit with a 10% early withdrawal penalty on top of that. And while you can withdraw Roth IRA contributions at any time penalty-free, you’re still robbing your future self of investment gains — something you may regret come retirement.
Alternative ways to finance a business
A small business loan
Small business loans come in a number of shapes and sizes. SBA (Small Business Administration) loans are long-term loans that may extend up to 20 years and beyond. They typically require a small down payment and, again, interest rates that generally range anywhere from 6% to 10%. If you’re looking for more of a one-time lump sum just to see you through the near future, a short-term loan may be a better bet.
But the biggest hurdle here is that few banks have a reputation for lending to start-ups. According to the Small Business Administration, personal savings remains the most prevalent source of start-up capital.
When applying for an SBA loan, the lender will be zeroing in on things like your business history, cash flow and earning potential, among other things. If you’re new to entrepreneurship, proving your ability to repay the loan may be challenging. If you’re one of the lucky few who make it through, Low adds that most banks will still require a personal guarantee before approving you.
“Therefore, it’s no different than you taking a loan against your house because you’re still 100% responsible for repaying that capital,” he said. “If you look at the rate you’re getting, you’ll find you can get a much better rate with a home equity loan than with a small business loan, and your personal liability is the same.”
Hit shows like “Silicon Valley” and “Shark Tank” have brought the start-up buzzword “angel investor” into the public vernacular. It’s just a fancy way of describing an individual who’s interested in investing in your start-up, usually in exchange for equity (aka a percentage of the business). It’s an effective financing method, especially since Low says that most private investors end up doubling as mentors.
“If you know you’re going to be spending outside capital, there’s a real advantage to going out early and finding sympathetic, supportive advisors who also contribute capital because they can help you refine the idea, open doors, and guide you in the development of your business,” he said.
It goes without saying that networking yourself and your company is no small thing in the start-up world. Low adds that successful businesses are built with a broad network of contacts who bring expertise, money, resources, talent, introductions and innovation to the table.
It’s all about relationships, which is what makes private investors so valuable. They may also be your only source of financing since venture capital firms, similar to banks, aren’t likely to take a gamble on a new start-up that’s just getting going. Private investors, on the other hand, represent a viable path forward for entrepreneurs who are open to the idea of not owning 100% of the company.
New entrepreneurs can also turn to crowdfunding platforms to attract new investors. Sites like SeedInvest nd Republic connect directly to interested parties. Sure, the experience isn’t as personal as having a mentor-type investor take you under their wing, but it’s still a way to raise real capital.
Sacrificing equity, and ultimately some control of the company isn’t for every business owner. If your dream is to create a business that you fully own and operate over the long haul, Low also recommends turning to your customers, if possible.
“There are better sources of capital besides home equity loans and outside investors, and that’s finding ways to engage your customers in long-term contracts that would either provide money upfront or potentially provide collateral where you could go and get credit from a bank,” he said.
A personal loan
A personal loan lets you borrow cash without any sort of collateral. The payment amount, along with the term and interest rate, is fixed, which means you’ll know exactly what you’re getting — no surprises. Every case is different, but the borrowing limit generally caps at $35,000, and the repayment timeline can range anywhere from two to 12 years.
The deal breaker here is the interest rate, which weighs heavily on your credit score. These days, personal loan rates cover a very wide range (anywhere from 3% to over 35%), with the best rates going to those who have:
- Good to excellent credit
- The ability to prove that they can repay the loan
- A low debt-to-income ratio
Locking down an affordable personal loan gives new entrepreneurs peace of mind because their home isn’t on the chopping block should the business go south. It’s also a better alternative than relying on credit cards, which Low says is “extremely risky.” In addition to high interest rates, maxing out your credit cards translates to a high credit utilization ratio, which can do a number on your credit score — and could come back to bite you when seeking future financing.
A 401(k) loan
Your retirement nest egg is another way to fund your start-up without risking your home. The IRS allows you to borrow up to $50,000 or half of your 401(k) balance, whichever is less, and it’s typically paid back through automatic deductions from your paycheck. This means you’re essentially paying yourself back with interest, but there are a few caveats.
If your business doesn’t do as well as you’d hoped and you’re unable to repay the loan, you’ll likely encounter a 10% penalty and have to pay taxes on the money because the loan is now considered a distribution. On top of that, if you quit your job or get laid off or fired, you’ll have to repay the entire loan balance by the next federal tax filing deadline.
Final thoughts on using a home equity loan to fund your business
A home equity loan is one of the most affordable, flexible types of financing around, but defaulting means losing your home. Borrowing against your house also means you’ll have to turn to other assets to see you through any financial emergencies that pop up during the repayment period.
If a HEL or HELOC feels too risky, and you don’t qualify for a small business loan, you may be better suited for private investors, a personal loan, or a 401(k) loan. The most important thing to remember is that entrepreneurs usually have more financing options than they think they do. It just requires thinking a little outside the box — something most small business owners are already good at.