If you're a small-business owner, you probably know how hard it can be to get your company off the ground. Starting and operating a small business often requires a sizable amount of capital, which can be difficult for small-business owners to obtain. About 77% of business owners use personal funds to grow their business, a strategy that can be even more tempting as lower interest rates make taking out home equity loans easier for many consumers.
The average homeowner with a mortgage was reported to have $113,900 available to draw from, even before rates dropped. And lower interest rates mean better access to funds that can be used to keep your company afloat for the first few years if you decide to go this route. However, using home equity for your small business can be risky.
Are you unsure of when to use home equity for your small business? Read on to learn about home equity and the pros and cons of borrowing against it.
What is a home equity loan?
Equity is the difference between how much you owe on a mortgage and how much it's worth. Over time, you build equity by paying down the mortgage. Let's say your home is worth $400,000 and you took out a $300,000 mortgage to buy the home. You've managed to repay about $100,000 of that mortgage, which would mean you have $200,000 of equity built up in the home. You could then apply for a home equity loan, which acts as a second mortgage, using the $200,000 as collateral.
Home equity loans are typically used for home repairs and renovations and allow the recipient to borrow against the value of their house. You have two options for borrowing against your equity: home equity loans and home equity lines of credit. Here's a brief overview of each:
Home equity loan: With a home equity loan, the lender releases one lump sum of money, with the written agreement you'll repay the loan with interest. The loan conditions will specify the loan term, interest rate and number of installments, which are usually equal. These are best for small-business owners who know how much they need to borrow and want a predictable monthly payment.
Home equity line of credit (HELOC): A home equity line of credit works like a credit card. The bank approves you for a certain amount of money, and you can draw from that line anytime, up to a maximum amount and usually during a certain time frame. The bank will assign an interest rate on the day you draw from the line, so your repayments will vary based on how much you borrow and the current prime rate. This type of funding is best for small-business owners who aren't sure how much they need to borrow.
Home equity pros and cons for small businesses
Using home equity can make your small-business dreams achievable, especially in a falling-rate environment. The Federal Reserve recently lowered the federal funds rate, meaning banks are lowering interest rates on home equity loans and lines of credit. That makes home equity loans more affordable for many people at the moment, but taking out any kind of personal loan for business has its drawbacks.
Consider the pros and cons of borrowing against home equity for your small business before moving forward.
- Home equity loans usually have lower interest rates than personal loans, which decreases the total amount you'll have to pay back. In fact, home equity loans typically have an interest rate ranging from 6%–10%, based on your creditworthiness, while small-business loans can fall anywhere from 7% to 30%.
- Small-business loans may come with limitations on how you can use the funds, while home equity loans have none. You can use a home equity loan or line of credit for pretty much anything, including small-business expenses.
- The interest you pay on a home equity loan or line of credit may be tax-deductible if used for home improvement. If you operate your small business from home, it might be worthwhile to explore if you can write off some of your more substantial home-improvement expenses, like an addition to make room for an office.
- Opening a small business is a big risk in itself, but putting up your home as collateral adds even more pressure. If your business fails and you can't make your payments, you may lose the home.
- Hidden fees can make home equity loans and lines of credit more expensive than they're worth. HELOCs could even be subject to inactivity fees, in which you're penalized for repaying the loan early. Compare the fees to the total amount you're borrowing to decide whether borrowing against home equity makes sense for your small business.
An alternative type of loan could offer similar benefits and better suit your business needs. For example, cash-out refinancing is a viable option for turning home equity into cash. With a cash-out refinance, you'll take out a loan that's larger than your original mortgage. The loan pays off your existing mortgage, and you get the rest of the money as cash.
If you've decided borrowing against your home equity is the best option for your small business, you'll first need to qualify for the loan. You should have a healthy personal credit history and a certain amount of equity in the home — this may vary with each type of loan and the bank. Start comparing loan terms at different lenders, and get your business plan kick-started.