Can You Use a Home Equity Loan to Start a Business?

Whether you are a current small business owner or still dreaming about starting your own business, finding the cash to finance your fledgling business can be one of the biggest challenges. Then, after starting up, there are the ongoing expenses associated with operating the business as you try to grow it to become profitable. Once you open the doors, you still need to pay bills like rent, utilities, wages, inventory, and many other types of operating expenses.

Startup costs and operating costs obviously vary by industry and initial size. Today, many small business owners start as freelancers who work out of their homes to minimize their costs. Growth is expensive.

Businesses that work on credit can have difficulty managing their working capital. Managing cash flow means having the funding available to pay your employees and bills that are due today while your clients may not be paying you for a few more weeks.

Whether you are a new small business owner looking to get your business off the ground or an existing small business owner struggling to grow and manage your working capital, you may be able to use a home equity loan to help fund your business. There are, however, many things to keep in mind if you choose this type of funding.

• Will your investment deliver a greater after-tax return than you’ll be paying for the loan? Does your home equity loan or line carry an adjustable rate? If so, a jump in interest rates may make what you owe even more expensive and further offset any gains you make in your investment. If rates fall, it’s good news, but given current conditions, it makes sense to be cautious.
• How much is property appreciating each year in your neighborhood on average? Is it enough to further offset the cost of your investment? Keep in mind that no one is predicting the type of double-digit property appreciation we saw before 2004. How will this loan work for you from a tax perspective? Keep in mind that interest on home equity loans is generally not tax-deductible if you aren’t using the debt to buy or renovate a property.
• What if you need your home equity borrowing power later for an emergency–the real reason most of us should open a home equity line and then avoid using it? Could you handle that emergency if your borrowing was strained to the maximum? How liquid is this investment? If you had a sudden major expense, could you turn it into cash without major hardship?
• How much other debt do you have? Do you have significant balances on credit card or auto debt? That may raise the rate you pay on your loan–another potential cut in your investment profit potential.
• From a cash flow perspective, will you be able to service the debt–make the loan payments–assuming your investment using the home-equity funds doesn’t work out?

Home equity loans allow homeowners to borrow against the equity they have built up in their homes. The application process is similar to the mortgage application process, and you’ll need to provide all the same type of documentation that you did when you applied for a mortgage as the requirements are similar. Small business owners can have a particularly difficult time documenting their income, so you should be prepared to provide several years of tax returns and business financial statements. You should also be prepared to pay closing costs roughly equal to two-five percent of the loan amount.

The amount of money you can borrow depends upon the current market value of your home and the outstanding balance on your existing home loan. Lenders use a target ratio called a loan-to-value (LTV) ratio. The total outstanding debt combining the mortgage and home equity loan cannot exceed around 80 percent to 85 percent of the current value of the home. So, if your home is currently worth $100,000, the combined debt from your mortgage and home equity debt can be a maximum of around $80,000.

Home equity loans are secured loans, which means your home serves as collateral for the debt. That means the lender can foreclose on your home if you are delinquent with your home equity loan payments.

On the other hand, the fact that your home serves as loan collateral means you can borrow at a relatively low-interest rate. Home equity loan rates are typically only slightly higher than mortgage interest rates. The loan term is usually around 10 to 15 years.

Small business loans are not dependent upon the equity you have in your home. Lenders, however, often require borrowers to provide an asset that serves as collateral for the traditional small business loan. The application process for a small business loan is even more complex than the process for the home equity loan. You’ll need to provide information about your personal financial condition and net worth in addition to your business plan and business financial statements. The amount of money you can get is highly dependent upon your personal finances and ability to repay the loan.

Most traditional small business loans and Small Business Administration (SBA) loans go to established businesses that need funding to grow an already profitable business. Lenders will have their own requirements about the number of years you need to be in business and your minimum annual revenue. If you have excellent personal credit and a highly profitable business, you might be able to get a small business loan with a good interest rate. Higher risk borrowers and businesses may receive interest rates that are much higher. Loan amounts can vary from as small as $500 to $5.5 million.