No matter the size or industry, running a small business isn’t for the faint of heart. Business owners have to learn how to adapt and multitask while managing any number of unexpected expenses that may arise.
The hard truth is that surprise expenses can occur in any business at any stage. Many businesses fail in their early years simply because they cannot address these expenses when they pop up. So how can a small business owner access the funds necessary to survive?
If you haven’t yet established a cash reserve fund and you’re a small business owner who also owns a home, you may be able to use a home equity loan to cover your company’s expenses. (This differs from using a home equity loan to start a business.) Before making this decision, though, consider several important factors.
In this guide:
- Should you use home equity to finance business expenses?
- Benefits and risks of using a home equity loan or HELOC for business expenses
- How does a home equity loan compare to other business financing options?
- How to take out a home equity loan for business expenses
- What if the company goes out of business?
Should you use home equity to finance business expenses?
It doesn’t matter how old your business is or what your business does: every day your business operates, you’ll need to manage expenses.
This includes:
- Buying new equipment
- Paying for large upfront costs
- Opening a new location
- Acquiring an existing business
- Launching a major remodel
- Covering payroll for employees
You must look for outside financing if your business can’t generate enough cash flow. Besides small business loans, investors, personal loans, and crowdfunding, you may consider pulling funds from your home equity. These loans may offer easier access or lower interest rates.
But while home equity loans may seem attractive, they can also be risky. You could lose your home to foreclosure if your business goes under while you repay the equity loan. If you can’t pay, your home equity lender can seize your property.
However, home equity loans might make perfect sense for some. For example, if you have funds available for a big purchase but want to hold onto your liquidity, a home equity loan may provide the funds you need at a lower interest rate than other financing options.
In the end, business owners should consider all the risks associated with a home equity loan before applying for one.
>> Read More: What can a home equity loan be used for?
Benefits and risks of using a home equity loan or HELOC for business expenses
As with most financial products and services, taking out a home equity loan has pros and cons, especially if it’s a home equity loan used for business expenses.
Pros
-
Home equity loans may cost you less.
Compared to personal loans, small business loans, or business lines of credit, a home equity loan often comes with a lower interest rate. This will save you more money over the life of the loan.
-
Qualifying may be easier.
Since home equity loans are secured by your home value, they may be easier to get than unsecured financing, such as personal or small business loans. A home equity loan may provide the cash you need if you have a newer business or don’t meet a lender’s revenue requirements.
-
They can offer faster access to funds.
Small business loans often involve a lengthy and complex underwriting process, including a review of your business’ history. A home equity loan can be fast by comparison and might even be completed in less than two weeks, depending on the lender and other factors.
Cons
-
You’re risking your home.
If you default on an unsecured business or personal loan, you risk your credit score and rating. If you default on a home equity loan or line of credit (HELOC), you are also risking the roof over your head. Proceed with caution.
-
You may not be able to borrow enough.
Business expenses can add up quickly, especially if you’re expanding your company or purchasing new equipment. While small business loans may offer hundreds of thousands in funding, home equity loans are limited to a certain percentage of your home’s value.
How does a home equity loan compare to other business financing options?
Business owners have options to finance their company’s operations or unexpected expenses aside from a home equity loan or HELOC. Here’s a look at several options and how they compare.
Home equity loan vs. credit cards
Credit cards are a popular financial tool for business owners in various different industries, whether you have a small home-based business or an international corporation. Benefits of using a personal or business credit card can include:
- Rewards. Many credit cards offer cash-back rewards, points, or miles on a range of purchases. In some cases, you might even earn rewards on every dollar your company spends. These rewards can be exchanged for cash, statement credits, travel, gift cards, and more.
- Introductory APR offers. Depending on the credit card, you may be able to take advantage of 0% APR on purchases, balance transfers, or both. With these zero-interest offers, you can pay off large purchases or existing balances over time without incurring new finance charges as you would with a loan.
- Employee access. Credit cards for small businesses often allow business owners to issue cards to authorized users such as employees. In many cases, you can even set separate spending limits for each card, giving your employees access to a specific amount of funds.
- Cash advances. Some business credit cards allow for cash advances, which are a withdrawal of cash against the card’s credit limit. These usually have higher interest rates and lower borrowing limits than purchases but can give business owners access to cash when they need it.
Of course, credit cards also present their own challenges. For business owners, a credit card involves:
- High interest rates. The interest rate on your business credit card will depend on the product itself as well as your creditworthiness. In most cases, though, this rate will be higher than the one you’d get with a home equity or business loan.
- Smaller borrowing limits. Depending on your credit history, business revenue, and the specific credit card you open, a business credit card may not offer a high enough limit to cover your expenses. A business or home equity loan can provide up to hundreds of thousands of dollars.
- Limited access to cash. Though many credit cards allow for cash advances, these withdrawals are limited to the overall credit limit of the card or less. If you need a substantial amount of cash to cover certain business expenses, this might not be enough.
Home equity loan vs personal loans
Small business owners may also consider personal loans for business funding purposes. These can sometimes be easier to obtain and offer certain benefits, such as:
- No collateral. Most personal loans are unsecured, so no asset is required for collateral. With a home equity loan, your property is used to secure the loan and can be seized if you default.
- No need for home equity. You can only obtain a home equity loan if you have enough equity established in your property. Even then, you are limited to borrowing against a portion of that equity. Personal loans are not contingent on equity.
- Faster financing. Depending on your lender and situation, a home equity loan can potentially take weeks to finalize and disburse. Personal loans, however, can often be funded the same or next business day for borrowers who qualify.
Of course, taking out a personal loan has its downsides, too, compared to a home equity loan. Cons include:
- Higher interest rates. Depending on your creditworthiness, lender, and the loan terms you’re offered, you might find that personal loans have interest rates well into the 30% or higher range. Home equity loans tend to have interest rates in the single digits or teens.
- Lower borrowing limits. Some personal lenders set borrowing limits as low as $40,000, which might not be enough to cover your business expenses. If you have the equity available in your home a home equity loan could enable you to borrow as much as $500,000 or more with certain lenders.
- Shorter repayment terms. With a home equity loan, you may be able to secure a repayment term of up to 30 years. Personal loans might be capped at just five years with some lenders, forcing you to repay your debt much faster and with higher payments.
- Stricter credit requirements. Since personal loans are unsecured, lenders rely on a borrower’s income and credit history. Home equity loans are still credit-based, but since they are secured by your home, lenders’ requirements may be less strict.
Home equity loan vs. small business loans
If you’re a business owner looking for funding, consider a small business loan. These are similar to home equity loans, giving you access to a lump sum when you need it most and often offering long repayment terms.
Here’s why small business loans might be worth a look:
- Limited liability. The right small business loan can help you create a strong division between your personal and business finances by limiting your personal liability for the debt.
- Larger borrowing limits. Depending on your business and the lender, you might be able to borrow more with a small business loan than you could get from a home equity loan. This is especially true if you have limited equity in your home.
Home equity loans might be a better fit if you need funding fast or have a shorter business history because:
- Underwriting can be extensive. Applying and qualifying for a small business loan—particularly a large one—relies on factors such as your business history, revenue, and available collateral. Approving these loans can be lengthy and may not get you the money you need when you need it.
- Business credit history matters. Unlike a home equity loan, which hinges on your home’s available equity, a business loan takes your company’s success into account. If you have a newer company or haven’t generated much revenue yet, you may not qualify for the loan you need to get to that next level.
How to take out a home equity loan for business expenses
Once you’ve considered the options and think a home equity loan used for business purposes is the right option, here are the steps you’ll need to take to qualify and borrow the money you need.
1. Consider how much you’re eligible to borrow
The first step in taking out a home equity loan for your business is to know how much you can borrow. While you may not know exactly what a lender will offer until you apply, you can get an idea of how much you can borrow.
Since home equity loans and lines of credit are based on the equity in your home, you can calculate the maximum loan you can take out.
Many lenders will let you borrow up to 80% LTV (loan-to-value ratio). If your home is worth $400,000, your combined debt could be as high as $320,000. If you still owe $200,000 on the property, your home equity loan would be limited to no more than $120,000 ($320,000 – $200,000 = $120,000).
Other factors determining your loan eligibility include your credit, income, and overall financial health. Knowing where you stand is important before you start shopping for a loan.
2. Choose between a HELOC and a home equity loan
Once you have an idea of how much you can borrow, it’s time to decide between a home equity loan and a home equity line of credit (HELOC). The right one depends on what you need the cash for and how you plan to spend it.
HELOCs act like credit cards. These revolving accounts allow borrowers to draw funds from their approved line of credit as needed. Use the money for any number of reasons (personal or business-related). The funds come with a variable interest rate.
A HELOC can also act as a safety net: you can get approved even if you don’t need the money yet. Then if a sudden expense arises, you have that line of credit available and at your fingertips.
Home equity loans are disbursed in one lump sum with a set monthly payment and loan term. They are often locked in at fixed interest rates. These are a better fit for borrowers who know how much they want to borrow or want to take out the maximum equity at once.
3. Compare lenders and loan options
Next, you should compare the various lenders and loan options available. This can help you determine which lenders offer the lowest rates and best repayment terms and might allow you to borrow the right amount against your home’s equity.
Many lenders offer loan preapproval with a soft credit check. This process won’t hurt your credit score but can give you an idea of whether or not you’d be approved for a loan and what you can expect in terms of interest rates.
4. Move forward with an application
Once you’ve decided which company to borrow from, it’s time to complete a full application.
During this process, you’ll be asked to provide all necessary documentation for the lender. This could include things like:
- Tax returns
- W-2s
- Pay stubs or other proof of income
- Proof of identity
Your lender will also want to order an appraisal to determine the current market value of your home. This tells the lender how much equity you have and how much you can borrow.
The lender will run a credit report to check your personal credit history. A disclosure outlining the loan and your overall costs will be sent ahead of closing.
Many steps are involved, each of which can affect the timeline of this process. While some home equity lenders can process and disburse a loan in as little as 11 days, a more typical time frame to expect is between 30 and 45 days.
5. Use the funds as needed for your business
Once your loan is complete, your borrowed funds will be deposited into the account of your choosing. You can then use the money as you see fit for your business, whether clearing out debts, purchasing new equipment, covering payroll, or paying for goods and services.
What if the company goes out of business?
The risk of taking out a home equity loan for your business is that your home is used to secure the debt. If you fail to repay the loan, your lender could begin foreclosure on your home. If this happens, you could lose your home while being in a tough place with your business and source of income.
Before taking out a home equity loan for business expenses, homeowners should consider the pros and cons. Compare all available funding options and repayment terms to determine if using your home’s equity is a viable option. Your unique situation will affect which option is right for you.