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.
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What is a Home Equity Loan?
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.
A Home Equity Loan vs. a Traditional Small Business Loan or SBA Loan
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.
The Risks of Using a Home Equity Loan for Your Business
The biggest risk of using a home equity loan as business financing is the risk to your home. If you can’t make your home equity loan payments, the lender will foreclose on your home.
If you are unable to make the payments on your home equity loan, it is probably because your business is in trouble. So, now you would be at risk to lose both your business and home. Entrepreneurship is inherently a bit risky, but you need to decide if this is a risk you and your family are willing to take.