Home Equity Loans for Businesses are Drying Up

As the mortgage crisis spills into other areas of the economy, many small business owners will lose an important source of capital. Home equity loans have been financing thousands of small companies, but that source of funds is rapidly becoming a thing of the past.

One advantage of rising real estate prices is that it allows homeowners an easy tool for financing small business ventures. As residential property values rise, many homeowners tap their newfound equity and use the money to launch or expand a business. But when the housing bubble recently burst-taking the subprime mortgage industry down with it-so did the schemes and dreams of many small business owners.

What goes up must come down

The reason businesses are so dependent on home equity loans is that, during the past decade, home prices rose to historic levels, enriching homeowners who also owned businesses by providing them with lots of automatic built-in equity. Folks who bought homes in the late 1980s and early 1990s, for instance, often paid an average of $75,000 to $125,000 for those houses. During the run-up in prices between 2000 and 2004, they watched those investments soar. The median price of a single-family home jumped to $250,000 nationwide, and in the red-hot real estate market of California, the typical house was worth more than twice that much. Some homeowners quickly doubled their equity, while others in rich regions (like the Golden State) became millionaires-at least on paper-as the value of their homes multiplied sometimes 10 times or more. Many used their homes like ATM machines, pulling out equity to keep businesses going or starting new ones.

Navigating the sea of bad loans

Now the cruel irony is that the mortgage industry itself is strapped for funds. Some of the biggest lenders in America are barely staying afloat, as they tread water in a sea of bad loans. Reacting to their own plight, they're imposing more stringent restrictions on their customers who want to borrow home equity loans. Those second mortgages are increasingly difficult to get, which is making it less likely that a business owner can look to home equity as a source of working capital.

To comprehend how much the availability of these loans has diminished, one only needs to look at the change in loan-to-value guidelines. As recently as last year, some lenders were offering loans equal to 95 percent of a home's value to borrowers with lousy credit. Now, the same lenders typically require stellar credit for a loan of only 80 percent of the property's market value.

Businesses will be severely challenged by the loss of those loans. Research conducted at Middle Tennessee State University recently revealed that nearly one out of five small businesses in its state was funded with a home equity loan. Other studies show that the use of home equity to finance business is even more widespread, and may account for close to half of small business loans in some regions.