Starting your own business is an exciting endeavor full of challenges and opportunities. But to do so requires money. One convenient option is using a home equity loan, as long as you understand both the benefits and drawbacks when it comes to tapping your home equity to fund your business.
Home equity loans have grown in popularity as property values skyrocketed across the country over the past two years. Home equity lines of credit, or HELOCs, are being used at their highest levels since 2007, but they can still be a risky way to fund a new business venture.
“The failure rate of business startups is very high, even among entrepreneurs who meet with eventual success,” says Greg McBride, chief financial analyst at CNET’s sister site, Bankrate. “Do you really want your home -- the roof over your head -- to depend on that?”
How does home equity work?
Home equity is the difference between what you owe on your mortgage and the current value of your home. To calculate your home equity, all you need to do is subtract your remaining mortgage balance from the current value of your home. You build up your home equity by making consistent monthly mortgage payments over the years.
When you borrow against your home equity, you are essentially taking cash out of your house that you must pay back with interest. If your business fails and you can’t pay back your loan, you could lose your house to foreclosure, which is why there are better alternatives to fund the start of your business.
The intended purpose of a home equity loan is typically home renovations or improvements that will increase the value of your property, but they can also be used for other life expenses such as paying off high-interest credit card debt, covering college tuition or building a business.
The two most common types of home loans are home equity loans and HELOCs.
- Home equity loan: A home equity loan provides you with a lump sum of cash at a fixed-interest rate. You receive all of your funds upfront and have predictable monthly payments over the lifetime of your loan.
- HELOC: A HELOC is an open line of credit that functions more like a credit card. You can make withdrawals from your HELOC account as often as you need (you don’t receive your entire loan upfront). HELOCs, however, have variable interest rates that rise and fall depending on economic conditions, so be prepared for your monthly payments to go up and down. With HELOCs, you can typically make interest-only payments for the first 10 years of your loan, known as the draw period, which helps keep your payments low for a while.
Why is a home equity loan an appealing choice to fund the start of a business?
Home equity loans can be a good choice to fund a business venture because they have high limits and long repayment periods, which offers you flexibility when repaying your loan.
- It’s easy to qualify: If you’re a homeowner with at least 15% to 20% equity in your home, good credit and a debt-to-income, or DTI, ratio of less than 36% (but no more than 43%), you should be able to qualify for a home equity loan relatively easily.
- High loan limit: Your loan limit could be much higher than a credit card limit or personal loan as it’s secured by your property. Your loan amount will also depend, in part, on how much equity you have in your house.
- Lower interest rates: Because your home serves as collateral to secure the loan, lenders can offer lower rates for home equity loans compared with credit cards or other types of loans, which are unsecured. Right now, the average rate for home equity loans is 7.77% and average HELOC rates are at 7.31%, according to Bankrate.
- Longer period to repay loan: Being able to repay your loan over a period of 20 to 30 years gives you flexibility in your budget, and keeps your monthly payments lower over time, too.
Why using a home equity loan to start your business is risky
It’s a risk to leverage your home (which is likely your largest asset) to start a business which may have unpredictable returns -- especially with a recession potentially on the horizon. Plus, as rates have crept up in the past year, home equity loan rates are no longer enticingly low, making them a less valuable financing option.
“Home equity borrowing is no longer a low-cost source of funds,” cautions McBride, who notes that HELOC rates are near 15-year highs. McBride also notes that as the prime rate rises above 7%, the variable rate is likely to increase further. “The cost of this borrowing is greater than we’ve become accustomed to, and so, too, is economic uncertainty. That’s not a good combination,” he says.
Among the more common reasons as to why it’s risky using a home equity loan to start a business:
- It puts your home at risk: Risking foreclosure is one of your most hazardous options for financing. If you can get a high enough credit limit with a business card or personal loan, then why jeopardize your home if you can’t make payments?
- It doesn’t build business credit: Just like personal credit, business credit is a measure of your business’ creditworthiness and ability to repay loans, and borrowing against your home equity won’t have any positive impact on your business credit.
- You need exceptional credit to qualify for the lowest interest rates: If you don’t have exceptional credit (a FICO score of 800 to 850) or very good credit (740 to 799), using a home equity loan may not actually save you that much money, as the best rates are only available to homeowners with so-called exceptional credit. Make sure the rates and terms you can lock in with a home equity loan are significantly better than what you can get with a credit card or personal loan. Otherwise, the savings are likely not worth putting the roof over your head at risk.
- HELOC interest rates are variable: In a rising interest rate environment, such as the one we’re in today, variable interest rates are unlikely to benefit you as a homeowner.
Better financial alternatives to fund the start of your business
There are less precarious ways to finance the start of your business than by using a home equity loan. Interest rates may be higher, but at least you’ll have peace of mind knowing that you won’t risk losing your home should your business go under.
- Business loan: A business loan doesn’t require putting your home up for collateral and can help build your business credit (make sure to confirm your lender reports your business loan to credit bureaus as not all do). There are also various types of loans available for people who have specific business needs.
- Personal loan: Personal loans are typically easier to qualify for than business loans, but they may have higher interest rates and lower credit limits. Right now, the average personal loan rate is 10.72%, according to Bankrate.
- Business credit card: A business credit card may offer you a low introductory rate, which is ideal in a high-rate environment, as well as rewards program benefits. But your credit card interest rate could be high -- the current average rate is almost 20% -- if you don’t already have solid credit.
The bottom line
You should avoid using a home equity loan or HELOC to start a business if you have other financing options that don’t involve using your home as collateral. New businesses have a high rate of failure, and risking your home to foreclosure isn’t worth it if you have other alternatives such as a business loan or credit cards.