If you want to start a business but can't fund it yourself, there are numerous financing options you can consider. As a budding entrepreneur, you can ask your family members to invest in your ideas, apply for business loans, pitch venture capital firms, use personal loans, and more. If you’re a homeowner, you can also use a home equity loan to fund your business.
According to the Federal Reserve’s Small Business Credit Survey, approximately 4% of businesses utilize home equity as a funding source for their business. The benefit of a home equity loan for business is you can use the funds for various purposes, including start-up capital.
If you want to learn more about using a home equity loan to start a business, here’s how it works.
Can I use a home equity loan to start a business?
Yes, you can use a home equity loan to start a business or to grow an already existing business. However, getting a home equity loan has advantages and disadvantages, and it's important to learn more about home equity loans before using one to fund your business venture.
How does a home equity loan work?
First and foremost, a home equity loan is a loan that uses your home as collateral. Typically, lenders allow you to borrow up to 80% of your home’s equity. Then, you make equal monthly payments for a set term.
Lenders will likely require you to have a certain amount of equity in your home, a specific credit score range, and a debt-to-income ratio under a certain percentage to qualify for a home equity loan.
The downside to a home equity loan is that if you cannot repay it, it’s possible your lender could foreclose on your home, a risk you should carefully consider.
Advantages of using a home equity loan for business
There are numerous advantages to using a home equity loan for your business financing.
Flexibility
When you get a home equity loan, there are no stringent rules or requirements regarding how you allocate the funds you receive. You can use the money for a variety of start-up costs, whether it’s to purchase inventory, pay rent, or make payroll.
Interest rates
The interest rate on a home equity loan tends to be lower than other financing methods. For example, home equity loans typically have lower interest rates than personal loans.
Speed
Typically, it only takes a few weeks to receive funds from your home equity loan, depending on the lender. If getting access to funds quickly is your priority, ask potential lenders how long funding usually takes before selecting one. A 30-day closing is common in the industry.
Disadvantages of using a home equity loan for business
Of course, there are also some disadvantages to consider before using a home equity loan for your business financing.
Risk of default
The biggest disadvantage and the most crucial one to be aware of is you could lose your home if you don’t make your payments. Your home is the collateral for your home equity loan. As such, assess your risk tolerance before funding your business with a home equity loan and make sure you understand the loan requirements.
Limited funding
You can only get a home equity loan for up to 80% of your available home equity. So, your loan amount is limited based on how much your home is worth and the equity you currently have in it. This might not work for businesses in need of large funding amounts.
Repayment regardless of outcome
Like any other loan, you are responsible for repaying your home equity loan. Even if you don’t create a profitable business and have to close it, you are still on the hook for monthly loan payments during your repayment period.
Income requirements
Most lenders will ask to see W2s to verify your income. If you are an entrepreneur and don’t have a full time, W2 job, this could present a challenge.
Won’t build business credit
When you apply for a home equity loan, you apply using your personal credit so it does not build your business credit. In order to build your business credit, you would need to open a business bank account and establish credit with vendors who report to business credit bureaus.
Applying for a home equity loan
If you're interested in applying for a home equity loan, there are a couple of steps to take.
Gather necessary documents
To apply for a loan, your lender will likely need documents like tax forms, proof of income, mortgage documents, your latest bank statements, and more. The documents required will vary by lender.
Select a lender
Do your research when it comes to selecting a lender. Getting quotes from three to five different lenders is important to find the best rate and terms. Pay attention to lender fees and not just interest rates when deciding which lender is best for you.
Be mindful of red flags
As you are researching lenders, be mindful of red flags. Write down the lenders you are considering, and speak with each one. If they give you an offer, ask for the terms in writing. If you have questions about the terms of the offer, ask questions.
Be wary of lenders who overpromise, ask you to borrow more than you need, or, in general, engage in practices that make you uncomfortable. If a lender won’t put their terms in writing or promises something outside of the listed terms, be wary.
Only work with a lender who makes you feel comfortable, who respects your budget, and who answers your questions clearly.
Alternatives to a home equity loan for business
If you decide not to take out a home equity loan to fund your business, several other funding options exist.
Small business line of credit
Many lenders offer businesses a line of credit they can access if necessary. This is similar to what a credit card offers, with some key differences. Typically, a line of credit offers a lower interest rate than credit cards. It’s meant to help business owners with operating expenses, and they come with set re-payment terms.
A small business line of credit is different from a small business loan, which might have different qualifications and equal payments over a period of time.
Small business credit card
A small business credit card works similarly to a personal credit card. If approved, you can use your credit card for business expenses up to your limit. Like other credit cards, business cards typically have a high interest rate. Credit cards are convenient for everyday business expenses, but they might not be the best financial option if you can’t pay them in full every month.
Unsecured loan
An unsecured loan is a type of loan that does not have collateral. A secured loan, like a home equity loan, uses your home as collateral. As another example, a car loan uses your car as collateral. There are specific qualifications to get approved for an unsecured loan, but it’s another option for entrepreneurs to consider if they meet them.
Cash-out refinance
A cash out refinance is when you get an entirely new mortgage and in the process, withdraw your equity in cash. This timeline for this product takes longer than getting a business line of credit or a small business credit card. It involves getting a home appraisal, paying closing costs, and securing a new mortgage loan, typically for larger than the mortgage you have.
HELOC
A HELOC is a Home Equity Line of Credit. It operates like any line of credit where you can use what you need up to a certain limit and repay what you used. Unlike a home equity loan, HELOCs can have variable interest rates. Both home equity loans and HELOCs utilize your home as collateral.
Home Equity Investment (HEI)
A Home Equity Investment is a financial product where you get upfront funds in exchange for a portion of your home’s appreciation in the future. It’s similar to an angel investor owning equity in your business in exchange for providing start-up costs. One benefit of an HEI is that there are no monthly payments. Your HEI partner earns money when you sell your home or when you decide to buy back your equity. There are also no income requirements.
Final thoughts
There are many ways to fund your small business, and getting a home equity loan is one. It’s important for entrepreneurs to be aware of the pros and cons of this financial product before applying for a home equity loan. However, if you understand the risks and want a straightforward funding option, a home equity loan can be a useful tool to help you start your business.
