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A brilliant idea isn’t all you need to start a business. You also need capital to get your venture off the ground. Getting a small business loan can be difficult without an operating history or revenue, so homeowners might consider a home equity loan or line of credit (HELOC).
Home equity loans and HELOCs allow you to turn the equity in your home into cash. Equity is the difference between what your home is worth and what you owe on the mortgage.
Taking out a home equity loan or home equity line of credit to start a business might be appealing, but we want to make sure you’re aware of the pros and cons. We’re breaking down how these borrowing options work and how you can use them to fund a new business or buy an existing business.
In this guide;
- How does using a home equity loan or line of credit to start a business work?
- Why is using a home equity loan to start a business risky?
- Is a home equity loan or line of credit better for starting a business?
- Is a home equity loan better than a business loan?
- Does borrowing money affect my ability to start a business?
- Can I use my home equity to buy a business?
- What should I do next if a home equity loan or line of credit is my best option?
How does using a home equity loan or line of credit to start a business work?
If you’re interested in using a HELOC or home equity loan to start a business, it helps to understand how they work. Both allow you to draw on your equity for cash.
Here’s a brief overview of their differences:
|Home Equity Line of Credit (HELOC)||Home Equity Loan|
|A revolving line of credit (similar to a credit card) that you can draw against as needed.|
May have a fixed or variable interest rate.
Pay interest only on what you draw from the credit line.
After an initial draw period (typically 10 years), repayment may last up to 20 years.
|Borrow a lump sum of money.|
Typically comes with a fixed interest rate.
Pay interest on the entire amount.
Repayment terms may last from 5 to 30 years.
To use either to start or purchase a business, you’ll first need equity in your home. Many home equity loan and HELOC lenders expect you to have a loan-to-value ratio (LTV) of 80% or lower. LTV measures your mortgage amount relative to the property’s assessed value by using the following formula:
(Outstanding mortgage balance / home’s current value) x 100
Imagine you owe $270,000 on a home worth $345,000. If you divide $270,000 by $345,000 (0.78) and multiply by 100, you know your LTV is 78%, which is sufficient if your lender requires an LTV of 80% or lower.
If you have equity in your home, weigh the benefits of using it to start a business. Here are the main pros of leveraging home equity for business costs:
- Easy to qualify. If you own a home, home equity loans and HELOCs are easier to qualify for than other loans, including small business loans, because of the collateral—your house.
- High loan limit. If you have significant equity, you can often borrow more than other loans.
- Low interest rates. Home equity loans and HELOCs can have lower interest rates than unsecured loans, which include personal loans.
- Long repayment term. Many home equity loans have longer repayment terms than other loans, making for a lower monthly payment.
If you opt for a HELOC, another benefit is paying interest on just the part of your credit line you’re using versus the entire amount with a home equity loan.
Why is using a home equity loan to start a business risky?
Home equity loans and HELOCs give you access to capital, but you should be aware of the drawbacks. Here are some of the main reasons to ensure using equity to start a business is the right decision:
- Putting your house at risk. If you can’t make payments on the loan, your lender could foreclose on your home, which usually isn’t a risk for unsecured loans.
- Upfront costs. Home equity loans and HELOCs often involve closing costs and other upfront fees, so you’ll need money to cover those expenses.
- Only an option for homeowners. If you don’t own your home or don’t have much equity built, you can’t get a home equity loan.
- Doesn’t build business credit. Business credit scores are separate from personal credit scores. If you want to establish and build business credit, a home equity loan or HELOC goes toward your personal credit score, so it won’t help.
- Need good credit for the lowest rates. While a HELOC or home equity loan can feature lower rates than a credit card, many lenders reserve the best rates for the most creditworthy borrowers. If you have a poor credit score, you may pay a steep rate to borrow against your equity.
Starting a business can be costly, and if you’re using a home equity loan or HELOC, it’s essential to understand your budget. Knowing you’ll be able to make on-time monthly payments can help you avoid the risk of losing your home.
Is a home equity loan or line of credit better for starting a business?
A home equity loan isn’t always better than a HELOC for starting a business, and vice versa. It’s a choice between a lump sum and a revolving line of credit. When comparing either as a business funding option, it’s helpful to consider the following:
- Minimum and maximum borrowing limits
- LTV requirements
- Other requirements, such as credit score and income
- Repayment terms
- Upfront costs and closing costs
- Interest rates, including whether fixed or variable
- Estimated monthly payments
A HELOC may be best if you’re unsure how much money you’ll need to borrow to get your business started or if you want flexible access to credit.
A home equity loan may be appropriate if you know how much capital you’ll need and prefer predictable monthly payments.
A home equity loan gives you the benefit of predictability since your payments won’t change if you have a fixed rate. That could make budgeting and calculating the total interest you’ll pay easier. If you repay the loan early, you’ll save on interest.
A HELOC with a variable rate option is less predictable, as the rate and payments can go up or down over time. You may appreciate having access to a revolving credit line if you’ll need funding on an ongoing basis to cover recurring operating expenses or gradual investment in business growth.
Is a home equity loan better than a business loan?
Business loans are designed to help you start, buy, or grow a business. Business loan options include the following:
- Small Business Administration (SBA) loans
- Business loans and lines of credit
- Term loans and equipment loans
- Alternative business loans, including merchant cash advances and purchase order financing
- Business credit cards
Each type of business loan is different when it comes to how much you can borrow, collateral requirements, credit score requirements, revenue requirements, interest rates, and repayment terms. Business loans are also different from home equity loans and HELOCs.
For instance, your equity determines how much you can borrow with a home equity loan or HELOC. With loans such as SBA 7(a) loans, on the other hand, it’s possible to borrow up to $5 million. You may pay higher interest rates for business loans than home equity loans or lines of credit.
A business loan could be the better option if you need to borrow large amounts of money and you meet the lender’s requirements. However, if that’s difficult because your business is brand-new, a home equity loan or HELOC might be favorable.
Does borrowing money affect my ability to start a business?
Borrowing money doesn’t affect your ability to start a business. It’s possible to launch an entrepreneurial venture with no money or collateral. You may need to legalize your business with local, state, and federal government entities, but your credit history and finances don’t factor in.
It’s up to you to decide how to finance operations for your business. If you choose to get a loan, you’ll need to be able to prove your creditworthiness. Lenders may consider the following:
- Credit reports and credit scores
- Annual income and sources of income
- Debt levels and debt-to-income ratio
- Assets, including savings accounts and investment accounts
- How you plan to use the money
You have other options if you want to avoid going into debt to start a business. You could bootstrap the company from your savings, borrow money from friends and family, or seek funding from angel investors or venture capital firms. Each option has pros and cons.
Can I use my home equity to buy a business?
Home equity loans and HELOCs allow you to use the money you borrow for almost anything, including buying an established business. You may decide to buy a business that’s already generating revenue versus starting one in order to make money right away.
If you’re considering a home equity loan to buy a business, remember to add up the costs. In addition to the purchase price of the business, you may need to pay other expenses at the closing, including:
- Any leases or other financial obligations you assume as the new owner
- Prorated taxes, including property taxes
- Attorney fees
- Accounting fees
- Prorated utility and insurance costs
- Lien searches and recording fees
Once the sale is final, you may need additional money to hire and train new staff if some of the business’s employees depart. If you plan to invest in new equipment or a rebranding campaign, factor in these costs when deciding how much of your home equity to withdraw.
What should I do next if using a home equity loan or line of credit is my best option to fund a business?
Using a home equity loan or HELOC to start a business could make sense if you’ve explored all other funding options and understand the risks. An unsecured financing option could be wiser if you have any doubts about your ability to keep up with payments to either type of loan.
Ready to draw on your equity to start a business? You can use our home equity loan calculator to estimate how much you might be able to borrow to fund your business.
If you’ve decided a home equity loan is the right way to go, you can access our list of the best home equity loans. And if you believe a HELOC is the better option, you can read through our list of the best HELOC rates and lenders.
Author: Rebecca Lake