If you’re at the beginning of your business journey, you probably know how hard it can be to get your small business off the ground. Starting, let alone operating a small enterprise, can be financially demanding. Obtaining a sizable amount of capital is even harder, which is why 77% of business owners employ private funds to jump-start their business, a strategy that can be even more attractive as lower interest rates make singing for equity loans sound as trouble-free as possible for many consumers.
And it’s easy to understand why: A home equity loan or home equity line of credit may be easier to get than other types of start-up financing. We can say that a strong personal credit and equity in your primary residence make the perfect recipe for using a home equity loan or home equity line of credit for one-time expenses or needed financial support for your business. But as with anything in life, there are some risks in using home equity for other reasons than financing your home, and you should know about them.
Home equity loan: The basics
An equity loan is a type of loan that lets you use the equity you’ve built in your home as collateral to borrow money. Home equity loans use properties as a security to protect lenders if borrowers end up defaulting on their loans.
HELs are often referred to as second mortgages as you have another payment to make besides your primary mortgage. They’re typically used for home repairs and renovations and allow you to borrow against the value of your home. There are two possibilities for borrowing against your home equity: HEL (home equity loans) and HELOC (home equity lines of credit). Here’s a brief introduction to each:
HEL: With a home equity loan, the lender will provide you with a sum of money; with the written agreement, you will repay the loan with interest. Here you should pay attention to different terms, interest rates and a number of instalments. Home equity loans are ideal to finance your business if you know exactly how much you need to borrow and want a predictable monthly payment.
HELOC: With a home equity line of credit, the lender will approve a certain amount of money, and you can use all that financing whenever you need, up to a maximum amount and during a certain time frame. The lender will designate an interest rate on the day you draw from the line, so your repayments will change based on your current prime rate and how much you borrow. If you’re unsure how much you need to borrow to finance your business, this type of funding is the way to go, but there are a few ups and downs that you should know about.
Unlike HELs, the home equity line of credit is a revolving source of income, much like a credit card, which homeowners can access whenever they want. Most banks provide varying ways for businesses to access those funds, such as online transfers, checks or credit cards. Unlike home equity loans, a line of credit has few closing costs and normally features variable interest rates – though some banks offer fixed rates for a given number of years.
Using a HELOC can make your small-business dreams achievable, especially in a low-rate environment. However, taking out any kind of personal loan for a business has its disadvantages.
- Easier to qualify for: Because you’re using your property as collateral – the lender deems the loan less of a risk. This is one of the reasons more and more small business owners turn to HELC, as it’s easier to qualify for than an unsecured loan.
- Lower interest rates: Unlike small business loans that come with a series of limitations on how you can use the money, home equity loans have none. You can use a HELOC for pretty much anything, including equipment upgrades or expansion.
- Flexible repayment periods: The line of credits comes with draw periods that last up to 10 years. This is a period you can use to withdraw money or repay interest on the amount you borrow. At the end of the draw period, you will get up to 20 years to repay the principal and interest.
- Larger amounts to borrow: With HELOC, you might be able to borrow a large amount of money. In fact, some banks will let you borrow up to 85% of your home’s loan-to-value ratio.
- If you can’t make your payments, you may lose your home: Financing your small business is a difficult thing to do in itself; putting your house as collateral adds even more stress.
- Variable interest rates: Though you may initially sign a HELOC with a low rate, it could rise in the future. This could cause your borrowing cost to rise – an unpredictability that can make it more difficult for you to repay your loan.
There’s an alternative type of loan that you could sign for similar benefits if agreeing on a HELOC scares you. You can opt for a more viable option for turning your home equity into cash, such as the cash-out refinance. This option will help you take out a loan that’s larger than your original mortgage. You can pay off your existing mortgage and get the rest of your financing as cash.
Finally, if you’ve decided to sign up for a home equity line of credit is the best option for financing your small business, you’ll first need to qualify for a loan. This will require you to have a healthy personal credit history and a given amount of equity in the home – this will typically vary from one lender to another. The first and the best step forward would be to compare terms at different lenders and get your business plan up and going.