A home equity loan or home equity line of credit (HELOC) is often used to make home repairs or remodel a house. They’re both a type of second mortgage on a home — with the home as collateral if the borrower defaults — so using a home equity loan on something risky such as starting a business should be done with care.
Succeeding as a small business is difficult, potentially leaving an entrepreneur and homeowner in the lurch if they’re using their home to help fund it and can’t repay the loan.
About 20 percent of businesses with employees fail in their first year, rising to about 33 percent in their second year, according to the Bureau of Labor Statistics’ Business Employment Dynamics report. About half make it to year five in business.
If you’re going to use a home equity loan or HELOC to start a small business, here are some pros and cons to consider:
Understand the differences
Home equity loans and HELOCs sound like they should be the same, and they are in one major respect — they’re a second mortgage on your home that you’ll have to repay. But they have many differences.
A home equity loan has a fixed rate, fixed rate loan amount and fixed repayment schedule. It’s a one-time lump sum loan that’s repaid monthly, like a regular mortgage.
However, a home equity loan has higher payments than a HELOC because you’re repaying both principal and interest each month.
A HELOC works like a credit card. It has a variable interest rate and you can use the equity when you need it, up to a predetermined amount.
You can borrow against it for a certain period, usually five to 10 years, and you’re only charged interest when you withdraw funds. You’re only paying interest during this draw period, so the monthly payments are lower while you’re not repaying the principal.
After the draw period it converts to a fixed-rate loan for repayment of the principle. You can no longer withdraw funds during this time and must pay off the entire HELOC balance.
An important thing to remember with a HELOC is that the interest rate will vary, so your costs will go up or down with the prime rate.
Home equity financing is easier
Traditional small business loans can require a lot of paperwork. A bank may require a projection of income and finance for the business, personal financial statements, business lease, business plan, and three years of tax returns, among other things.
The smaller your business, the less likely you are to get a bank loan. About 15 percent of sole proprietorships have business loans, according to the National Federation of Independent Business.
Home equity, however, can be easier to get. Home equity lenders aren’t concerned with your business plan, but with your personal resources. If you have the income, equity and credit rating to repay the loan, you’ll likely get the loan or line of credit.
Lower interest rates
Home equity interest rates are lower than business loans because the mortgage lender isn’t taking on the risk of your business. That’s your risk. If your business fails or isn’t as successful as you expected, you still have to repay the loan or lose your home.
The low interest rates offered on HELOCs can be misleading because the rates vary during the loan period.
“Beware of the equity line’s seemingly lower interest rates,” says Rob Drury, executive director of the Association of Christian Financial Advisors. “While most equity loans are fixed rate simple interest, most HELOCs are offered at revolving variable rates, similar to credit card accounts.
“Given an equivalent APR, the line accumulates interest far more quickly, and the rate is subject to change,” Drury says. “The best option may be to obtain a loan for an amount expected to cover immediate or short-term needs, plus an equity line for amounts in excess.”
A home equity loan may be best for one-time businesses expenses, while HELOCS may be better used by business owners as a cash reserve over time.
Money from a home equity loan or line of credit can be used any way you wish, while business loans are often restricted in their use.
The interest on a home equity loan or HELOC may be tax deductible and you don’t have to pay it down to zero every year, as most business lines of credit require, says Casey Fleming, author of “The Loan Guide: How to Get the Best Possible Mortgage.”
Interest paid on home equity debt can generally be deducted up to $100,000, or $50,000 if you’re married and filing separately, according to the IRS. Interest paid on bank loans, personal loans, credit cards and other types of loans isn’t deductible.
But that flexibility with home equity borrowing comes at a cost. When pledging your home as collateral, the debt generally can’t be discharged in bankruptcy if the business fails, Fleming says. “And you won’t be able to refinance or consolidate until you have at least two years of profits under your belt,” as shown on your tax returns, he says.
“If you do use a HELOC to finance your business, pay vary close attention to making sure the business is profitable as quickly as possible,” Fleming says, “and put yourself in a position to refinance or pay off the debt as soon as you can to mitigate the risks to you personally.”
Types of businesses to use home equity financing
Risking your home on a business that typically has a lot of risk associated with it, such as a restaurant or retail business, can backfire if you don’t make enough money to repay the loan. Spending home equity on inventory can be a bad idea because if the inventory’s value drops over time or no one buys it, you can lose money.
Service industries that don’t focus on a product that consumers may not like may be the best areas for business startups with home equity financing.
It worked for Sam Craven, owner of Senna House Buyers in Houston. Craven says he pulled $25,000 out of his primary home through a HELOC five years ago and now has done close to 300 deals with eight people working for him.
“It was an easy process,” he Craven says of the HELOC. “They lent me 80 percent of my home’s value and that was enough seed money to get the ball rolling.”
“I would highly recommend people unlock the dead equity that is sitting in their home to chase their dreams,” he says. “I sold the house last year, made $80,000 on the appreciation after paying off the HELOC. I moved out of the house three years ago and cash flowed $1,000 a month while it was rented out.”