One of the biggest challenges most aspiring business owners face is finding the capital needed to launch. If you’re starting a business, one financing option you might want to think twice about is tapping into your home equity.
There are a variety of ways homeowners may use home equity to start a business:
- A home equity loan provides a fixed amount of money from a loan that is secured by your home. You typically repay the loan in equal monthly installments over a fixed term, similar to a traditional mortgage.
- A home equity line of credit (HELOC) provides a line of credit that you can draw from as needed over a fixed period. You only make payments on the outstanding amount at any time.
- Cash-out refinancing replaces your existing mortgage with a new loan at a higher amount. You receive the difference in cash that can be used for any purpose.
A HELOC isn’t a particularly popular way to fund a small business. According to a report from the Federal Reserve, just seven percent of all small business owners who apply for loans or lines of credit do so with a home equity line of credit.
That’s probably a good thing, because using home equity to start a business can be problematic. Here’s why.
1. They’re Risky
Home equity loans, HELOCs and cash-out refinancing uses your home as collateral. While that usually means you’ll get a lower interest rate on a home equity product than you would on a credit card or personal loan, it puts your home at risk.
If your business is slow to make a profit and you have trouble making the loan payments, the lender may foreclose and take your house.
Think it won’t happen to you? Small business failure is pretty common. According to the U.S. Small Business Administration, only about half of all new businesses survive five years or longer.
2. They’re Costly
Interest rates may be low, but home equity loans, HELOCs, and cash-out refinance loans typically come with an assortment of closing costs and fees. While those costs and fees vary from lender to lender, they typically average anywhere from two percent to five percent of the amount borrowed.
Many lenders will allow you to roll these into the loan amount, but they will increase your cost of borrowing. Refinancing a current loan can help, but make sure to shop around and compare at least three lenders to get your lowest rates.
Home equity loans in particular may be a risky choice: Interest rates on home equity loans are usually higher than those offered by home equity lines of credit (HELOCs) because home equity loans have fixed interest rates while HELOC rates are variable.
In times of falling interest rates, paying a fixed rate on a home equity loan can leave you paying more interest over the life of your loan.
3. The Interest May Not be Tax-deductible
For years, one of the advantages of borrowing against your home’s equity was the tax deduction that came with it. Homeowners could deduct the interest expense on up to $100,000 of home equity debt, no matter how proceeds of the loan were used.
That’s no longer the case due to the Tax Cuts and Jobs Act of 2017. Starting in 2018, the interest on home equity loans and lines of credit is only deductible if the funds are used to “buy, build or substantially improve the taxpayer’s home that secures the loan.”
4. Time-consuming Approval Process
Before you can get approved for a home equity loan, HELOC or cash out refinance, the lender will need to review your credit and verify your income and assets. They may ask for a copy of the deed to your home, copies of pay stubs and tax returns, and require an appraisal of the property.
The time it takes to close on a home equity product varies, depending on the lender and your unique financial situation, but it typically takes at least four to six weeks. If you need funding fast, borrowing against your home’s equity may not be your best option.
5. You May Not Have Enough Equity
Home equity lenders typically limit the amount you can borrow up to 85 percent of the value of your home, including your first mortgage. For example, if your home is worth $300,000 and you have an existing mortgage balance of $250,000, few lenders will let you borrow the remaining $50,000 of equity in your home. In most cases, the most you could get is $5,000, since your first mortgage is already using more than 83 percent of your equity.
6. You Could Wind up “Underwater”
If home values decline, you could wind up being “underwater” on your home, meaning you owe more on the property than it’s worth.
If you’re underwater on your mortgage and need to sell your home for any reason, the sales proceeds won’t be enough to pay off your loan or line of credit and you could wind up being on the hook for the remaining balance. You’ll also have a hard time refinancing.
Alternatives to using home equity for your business financing
If the above hazards convinced you that using home equity to fund your business isn’t your best option, here are some alternatives to consider:
- Small business grants. Many government agencies, states, non-profit organizations and corporations offer grants to help small businesses get off the ground. Many are also tailored to certain demographics, like women or minority groups. Unlike a loan, grants don’t have to be repaid. However, the application process can be complicated, and some grant programs are specific about how the money can be used.
- Personal or business credit cards. Credit card financing is usually easier to get, but the interest rates can be high. If possible, take advantage of introductory rates — such as 0% APR for 12 months. Just make sure you can pay off the debt before the end of the introductory period.
- Personal savings. Using your own money to start a business is easy and cost-effective. However, not everyone has enough personal savings to entirely finance their start-up. If you do use your savings, make sure you have enough left over to cover an emergency fund in case you need extra cash for an expensive car repair, unexpected medical bills, or other financial difficulties.
- Small business loans. The SBA provides loans to many small business owners who might have trouble qualifying for traditional business financing. SBA loans often require a lengthy application and a lot of documentation, but interest rates are capped to keep them affordable.