Key takeaways
- Homeowners can use their equity to fund a business through cash-out refinances, home equity loans/lines of credit, and equity sharing agreements.
- Tapping your home equity may allow you to borrow more money at a lower interest rate than a small business loan or personal loan.
- The biggest risk of using equity: It pledges your home as collateral for the debt. So if the business fails and you can’t repay, the lender could foreclose.
Funding your own business can be difficult, especially for a first-time entrepreneur. Here’s where being a homeowner can help.
If you own a substantial amount of your home outright (no longer mortgaged, that is), there are a variety of ways to get funds to kickstart your business. Cash-out refinances, home equity loans, lines of credit and equity sharing agreements are all ways to access cash from your home.
However, the downside is that your domicile becomes the collateral for the money you borrow. So, if your business goes south and you default, you could lose your home.
Here is what you need to know about taking out your home equity to invest in your business.
Home equity loans vs. business loans: What’s the difference?
While they’re both forms of financing, a home equity loan differs from a business loan in several ways.
A home equity loan or line of credit (HELOC) is a debt that’s secured by your home, similar to a mortgage. Basically, it allows you to borrow against your equity stake — the portion of your home that you own outright, as opposed to the amount owed on your mortgage — up to a certain percentage.
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For example, let’s say your home was purchased for $350,000. You put down $50,000, and took out a $300,000 mortgage. A few years later, your home appraises for $500,000, and you have $200,000 left on your mortgage. You would then have $300,000 in equity and could borrow up to 80 or 85 percent of that, depending on your lender (most won’t let you totally tap your ownership stake, make you maintain a certain amount in the home).
Home equity loans often have long terms — 10 to 20 (or even 30) years and fixed interest rates. HELOCs typically offer variable interest rates. Your personal financials, such as your credit score, income and debts, factor into the sort of interest rate a bank, credit union or mortgage company might offer you.
In contrast, a business loan is a loan taken out against your (new) company or enterprise. It may be secured or unsecured, but if the former, assets or something else related to the business usually acts as collateral. You get the funds in a lump sum, though business lines of credit also exist.
Terms can vary greatly, but small business loans tend to have shorter terms than home equity loans. They often require a strong personal and corporate credit history, including credit scores — or a strong business plan/projections for earnings (for start-ups). Repayment of the loan should come out of business income.Commercial business loans and lines of credit also may carry higher interest rates than home equity loans. The current average home equity loan interest rate is 8.39 percent (slightly higher for HELOCs), whereas a $50,000 SBA microloan (tailor-made for start-ups and fledglings) could charge up to 13 percent interest.
How do you tap home equity to invest in a business?
There are several different ways to tap your home equity to fund your business idea. Here are some of the most common.
Cash-out refinance
A cash-out refinance mortgage is a new, bigger mortgage loan on your home that replaces your current one. You can take the difference between the two loans in cash.
How much cash you can access depends on the equity you have in the home. You may also be able to change the terms of your mortgage, including the length or term of repayments and the interest rate.
Pros of using a cash-out refinance
- Avoid adding a second lien onto your home
- You can redefine your current mortgage terms
- One payment a month vs a mortgage payment plus a loan payment
Cons of using a cash-out refinance
- Time-consuming application process (similar to taking out first mortgage)
- Depending on current interest rates, you may end up with a larger monthly mortgage payment
- You will have to pay closing costs and other fees
Home equity loans and HELOCs
Home equity loans are fixed-rate loans that let you borrow a specific amount, received in one lump-sum payment. Unlike a cash-out refinance, a home equity loan doesn’t replace your original mortgage. Instead, it becomes a second lien on your property. In fact, these loans are often known as second mortgages.
A home equity line of credit (HELOC) is a revolving line of credit with a variable interest rate that will rise and fall over time. Unlike a home equity loan, a HELOC allows you to use the funds, repay them and then borrow again, somewhat like a credit card.
You can borrow money during what is known as the draw period, often 10 years. After that, you re-enter the repayment period of the HELOC. You can no longer withdraw funds, but only repay your debt. This period usually lasts up to 20 years.
Because your home is the collateral for the loan, you can fall into foreclosure if you fail to repay your home equity loan or HELOC.
Pros of using a home equity loan or HELOC
- Long repayment periods; with HELOC, option just to repay interest at first
- Relatively simple application process
- Only pay interest on sums you actually withdraw (HELOC)
- Possible tax deduction of loan interest (if funds used on home — say, to build addition for the business)
Cons of using a home equity loan or HELOC
- You put your home at risk if you default
- HELOC repayments can vary, due to fluctuating interest rates
- If your home declines in value, you could find yourself owing more than the home is worth
Equity sharing agreement
Another route to accessing your equity is by entering into an shared-equity agreement. This isn’t a loan so much as an investment. An equity-sharing company pays you for a portion of your home’s future value, to be repaid when the agreement expires or when you sell the house. Essentially, the company will own a stake in your home. Exact arrangements vary, but typically, at payback time, you return the initial investment, plus a percentage of the home’s appreciation.
Home equity sharing agreements often come with lower credit and income criteria than a refinance, home equity loan or HELOC; they’re frequently geared to people who can’t qualify for more traditional financing. Unlike home equity loans, no monthly payments or interest are charged when you enter an equity-sharing agreement — helpful if your cash flow is being consumed by your new venture — and the money is disbursed in a lump sum.
Pros of using an equity sharing agreement
- No monthly repayments of principal or interest
- Often easier to qualify for than home equity loan or refinance
- Long period until repayment
Cons of using an equity sharing agreement
- May not receive as much in funding
- Repayment due in one big lump sum
- Could conceivably end up repaying much more than you received or what you would’ve paid in loan interest
How to fund your business with home equity
Cashing in on your equity to start your business takes some planning. While the requirements can be less stringent than for a business loan, and the process less onerous, approaching the application with a strategy and an idea of what to expect will better set you up for success.
1. Make a plan for your business.
While you technically aren’t required to provide a business plan to cash out your equity, it’s still a good idea to outline how you’ll build your business, what your target audience is, what your overhead will be and how you plan to profit. This will help inform you how much money you need and when you can pay it back.
2. Research options and providers
Consider each equity cash-out method when deciding how you’ll fund your business. The pros and cons of different home equity methods to start a business vary; for example, a HELOC can provide a more flexible cash flow than a lump sum from a refinance or an equity loan.
The interest rate you’ll get will impact how much you’ll end up paying back, so shop around and make sure your credit is strong for the best rates.
3. Check your requirements
All cash-out refis and home equity loans come with equity and credit score minimums. Many lenders require you to keep around 20 percent of your equity untouched, allowing you to borrow up to 80 percent of it (some let you go as high as 90 percent). Credit score and income requirements vary, but will generally be around the mid-600s for home equity loans, refinances and HELOCs.
4. Figure out how you’ll repay
Paying back your loan is an integral part of your business and long-term financial plans and one of the challenges of starting a small business.
Depending on which method you choose, you may have to make payments on your loan straight away — which can be an issue if you don’t immediately turn a profit. Make sure to have a way to make the monthly payment when you have a slow month. With a home equity agreement, since the payment is provided upon the sale of the house or at the end of the agreement, you don’t have to make a monthly payment. But bear in mind that you’ll be making a big payment at the end.
5. Gather the necessary documents
Depending on which method you select, you must provide your servicer with documentation relating to your credit score, homeownership and taxes. Some banks allow you to apply online; others require an in-person application.
6. Apply and wait
Once you’re ready, go ahead and apply. Your servicer may pre-qualify you for a certain amount, giving you a benchmark of how much cash you’ll receive. You’ll also have to undergo a house appraisal to determine how much the home is worth, alongside other possible application requirements. Depending on the method, it can take you anywhere from a couple of weeks to a couple of months to get your money.
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