Entrepreneurs funding new businesses often take loans against their assets — including their homes — in order to pay for business expenses. Using home equity to bootstrap a business has both pros (low interest rates) and cons (risking your residence, should the business fail). Roughly 7% of American entrepreneurs tap their home equity to help finance their startups, according to the U.S. Census Bureau’s most recent Annual Survey of Entrepreneurs. Barlow Research, a firm in Minneapolis, Minn. that tracks small-business borrowing, estimates that as many as 25% of entrepreneurs use home equity loans or use their home as collateral to secure business loans.
If you’re an entrepreneur considering tapping home equity, read on for information about whether this option is right for you, and how to go about it.
Tapping home equity for your startup
Home equity loans come in a few flavors. But before you can apply for one, it helps to understand how home equity works. Here’s a simple formula:
Your home’s current value – the amount owed on the mortgage = home equity
If your home is worth $400,000 and you owe $300,000 on your mortgage, you have $100,000 worth of equity (or 25% equity) in your home. Home values can fluctuate, depending on local market dynamics and time of year, but you can ask a real estate agent for an estimate or use online tools to get a sense of your home’s value. If you apply for a home equity loan, your lender will arrange an appraisal to confirm value.
Generally speaking, lenders who offer home equity loans like to see that you have at least 20% equity in your home before applying for a home equity loan. Unlike a credit card or bank loan, a home equity loan is secured against your residence. This means that if you fail to repay the loan or you enter delinquency, the lender can place a lien on your property or pursue foreclosure in an effort to recoup the debt. Lenders generally don’t want to see you borrow more than 85% of your home’s value. This means that if you have 25% equity, as in the formula example above, you could borrow no more than 10% equity — or about $40,000 in the example — as that would bring your total equity down to 15%.
A home equity loan may be offered as a second mortgage: With this type of loan, you are given funds in a lump sum that you repay at an established interest rate over time. Or, you may tap home equity through a home equity line of credit (HELOC). With a HELOC, the lender sets up a line of credit based on your home equity, and you can tap that credit fully or partially when you wish, provided you make monthly minimum payments on any balance you carry (as with a credit card) over time; some HELOCs may be extended at the end of their terms. HELOC interest rates may be fixed or variable. Unlike a second mortgage, which provides a single cash infusion, HELOCS allow you to “run up” and “pay down” a balance as needed during the life of the loan.
What are the benefits to tapping home equity to fund a startup?
There are several benefits to tapping home equity to fund a startup:
- Interest on home equity debt is generally tax-deductible.
- Because home equity loans are secured against your property — rather than your credit score alone, as with a credit card — they generally carry lower interest rates than other loan options such as personal loans, credit cards or bank loans.
- Business owners who establish a HELOC can draw on funds when they are needed, and thus only pay interest once the line is put into use. For this reason, establishing a HELOC “just in case” may make sense.
What are the risks?
There are downsides to using home equity to fund a startup, too:
- Home equity loans have been “called in” during market shocks. During the Great Recession, when home values fell precipitously, lenders froze, canceled and “called in” HELOCs that had been written against higher home valuations.
- Home equity loans contribute to personal debt loads and create new monthly payments, which may affect credit scores and household finances at the personal level (rather than within the business).
- Home equity loans don’t measure business metrics the way bank, small-business loans or venture capital (VC) investors would. A Harvard study notes that traditional bank loans look at the business to which they’re lending and the business’s metrics to determine whether it is creditworthy. But home equity loans aren’t correlated to a business’s viability, which means a lender is offering funds against the secure asset of a home (which can be seized) rather than the likely success of a business. While many small-business owners fall below banks’ strict lending criteria, failing to qualify for bank loans might raise worthy questions to oft-optimistic entrepreneurs about whether they need to strengthen their business first. Those who use home equity don’t receive this scrutiny.
What are business-funding alternatives?
Entrepreneurs can pursue multiple avenues to secure funding, from taking friends and family investors to personal loans, regional economic development grants or incentives, borrowing from retirement savings and more.
- Small-business loans: The U.S. Small Business Administration (SBA) offers loans through 800 lenders in 50 states. Loans range from $500 to $5.5 million to small businesses that are U.S.-based, for-profit, and where the business owner has made a financial and/or time investment into the company. Also, the borrower must have exhausted other financing options, and the business cannot get funds from any other financial lender.
- Venture capital funding: Venture investors bring more than just money to your business — they also bring industry expertise about best practices in your sector and social networks that can be useful for board development or business deals. Often, VC firm partners are investing their own money (or that of affiliated business leaders) into your business, so they are motivated to help you succeed. This form of funding is not easy to secure, can take a long time and VC investors may want guaranteed control of aspects of your business (board seats, executive decision-making ability, etc.) Venture capital firms focus primarily on technology, biotech, mobile and computer-driven businesses.
- 401(k) loan: You can take a loan from your own 401(k) retirement plan of up to $50,000 or half your vested balance, whichever is smaller. Repayment time frame is generally five years, with extensions possible to 15 years. If you’re under 59 and a half, you will likely face a 10% penalty for early withdrawal. However, if your credit doesn’t pass muster in other loan scenarios, 401(k) loans may be an option.
- ROBS: You can also do a 401(k) rollover to your new business through a maneuver known as “Rollovers as Business Startups.” This gesture allows you to sidestep the early-withdrawal penalty or loan fee from a conventional 401(k) loan and secure funding for your business without a credit check. However, you will need to form the account through a ROBS specialist and make sure to follow IRS rules.
Running a startup business is demanding but rewarding. Entrepreneurs must choose which available financing resources make the most sense at different intersections in their business’s life cycle — and their own. Home equity is a viable option for many business operators, but not the only resource for supporting the needs of a growing company.
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