With traditional business loans often difficult to obtain, some small business owners instead turn to their biggest asset for cash: the equity in their homes.
Compared to getting a loan from a bank, which can be a lengthy and complicated process, “it’s relatively easy to get a home equity loan or line of credit, provided you have equity in the home, good credit and income to support the repayment,” says Craig Smalley, a small business lending expert.
But using the equity in your home to finance your small business comes with numerous risks, so it’s wise to weigh all of the pros and cons to determine if this strategy is right for you.
Home equity loan or line of credit?
It’s important to understand the differences between your two home-equity borrowing options.
Home equity loan: This is a one-time lump sum loan that is repaid monthly at a fixed rate, just like a regular mortgage. It’s very predictable because you’ll have the same exact payments each month. However, your payments will be higher than a line of credit because you’ll be repaying both principal and interest each month.
Home equity line of credit (HELOC): This works more like a credit card, as you’ll have access to a set amount of money and can draw down funds whenever you need cash. You then re-borrow and repay it as many times as you want during the draw period, and you won’t be charged interest until you withdraw funds.
Keep in mind that the interest you are charged will most likely be a variable rate, which means your interest costs can go up or down depending on the prime rate.
“When you get a traditional loan, you have to guess right on how much money you need,” Smalley says. “If you need more, it would be hard to get another loan. With an equity line, you can take the money as you need it.”
HELOCs usually come with a draw period and a repayment period. The draw period is a time where you’ll be able to borrow as much as you’d like within the credit line limit and can last anywhere from five to 10 years. Because you only repay interest during the draw period, this results in low monthly payments, since you’re not repaying principal.
It’s then followed by the repayment period, where you’re no longer able to withdraw funds and you’re required to pay off the entire balance of the HELOC.
So which loan type is best for you? Home equity loans are likely better suited for business owners who need money for major one-time expenses, like the purchase of equipment or real estate, while HELOCs are better if you need access to a reserve of cash over a period of time, whether it’s to manage cash flow or for financial flexibility.
1. Lower interest rates: Home equity interest rates are likely to be far lower than your other borrowing options, including bank loans, since the loan is secured by your home.
The average interest rate for home equity loans is 6.16% and the average rate for a $30,000 HELOC is just 4.78%, according to Interest.com. This compares very favorably with bank loans (7% to 10%), microloans (8% to 15%), and online term loans (7% to 25%).
2. Flexible borrowing: You can use the money from a home equity loan any way you wish, while business loans often come with restrictions on how you can use the cash.
HELOCs are an effective way to solve a working capital shortfall if you come upon a time when you are waiting for clients to pay you, Smalley says.
For example, instead of taking on a costly form of short-term financing, like a cash flow loan (25% to 90% interest), an accounts receivable financing (15% to 25%), or a merchant cash advance (70% to 350%), business owners can instead tap into a home equity line and simply repay the line when they receive the money from their clients. While you’ll pay some interest to do this, it will likely cost far less than the options mentioned above.
3. Tax-deductible debt: Interest on a home equity loan or a line of credit is deductible if you used the money to buy, build or substantially improve your home, according to the IRS.
You can generally deduct interest on mortgage and home equity debt up to $750,000, or $375,000 if you’re married and file separately. The interest you pay on personal loans, bank loans, credit cards and other loans likely isn’t deductible.
1. You put your home and business at risk: Your home is used as collateral for both a home equity loan and a HELOC. While this results in a lower interest rate on the loan, it can also result in foreclosure on your home and the loss of your business if you fail to repay.
2. Closing costs and fees: Home equity loans and HELOCs come with closing costs, which usually includes upfront costs like application and appraisal fees, attorney fees, a title search charge and loan processing fees.
In addition, HELOCs might come with annual fees, inactivity fees if you don’t draw funds from the account for a specific period of time, and an early repayment penalty if you pay back the loan balance early. The total amount you pay in fees will ultimately depend on the lender you choose and its individual policies, so choose carefully.
3. Interest rate risk: While home equity loans are fixed-rate loans, HELOCs usually come with a variable interest rate that is based on the prime rate. This means your payments will rise or fall depending on market interest rates, so it’s difficult to budget for this monthly expense.
An increase in interest rates could make your new monthly payment unaffordable, resulting in a default on the loan, so this is a huge risk to consider. To combat this risk, you may want to choose a home equity loan or a HELOC with a fixed-rate option, even though your monthly payments will likely be higher.
Who should use this type of financing?
Using an equity line to purchase a restaurant or retail business likely isn’t a good idea, because they can become money pits, and getting the money to repay the loan would take a lot of time, Smalley says.
“If you are using them to buy inventory it can also be a bad idea, because the value of the inventory could become worth less than what you purchased it for,” he says.
Instead, people in service industries like consulting, legal services, health care and social services are best suited for these loans. They’d be able to repay the loan in less time because they are selling a service, rather than a product that consumers may not like, according to Smalley.
If you are confident in your ability to repay the loan, using a home equity loan or a HELOC comes with numerous benefits that can help you grow your business.
But no matter which financing route you choose, always remember to shop around for the best deal, comparing loan terms, fees and interest rates, and read all of the closing papers carefully.
Looking for a small-business loan?
NerdWallet has created a comparison tool of the best small-business loans to meet your needs and goals. We gauged lender trustworthiness, market scope and user experience, among other factors, and arranged them by categories that include your revenue and how long you’ve been in business.
House and money image via Shutterstock.