Starting a business is a risky venture, so you need to think carefully about leveraging your home to build one.
Starting your own business is an exciting endeavor full of challenges and opportunities. But to do so requires money. One convenient option is using a home equity loan, as long as you understand both the benefits and drawbacks when it comes to tapping your home equity to fund your business.
Home equity loans have grown in popularity as property values skyrocketed across the country over the past two years. Home equity lines of credit, or HELOCs, are being used at their highest levels since 2007, but they can still be a risky way to fund a new business venture.
“The failure rate of business startups is very high, even among entrepreneurs who meet with eventual success,” says Greg McBride, chief financial analyst at CNET’s sister site, Bankrate. “Do you really want your home — the roof over your head — to depend on that?”
As a small business owner, access to capital is crucial for starting and growing your company. Two common options for financing are business loans and home equity loans. But how do you decide which one is right for your situation?
I’ve taken out both types of loans for my businesses over the years. In this article, I’ll compare business loans and home equity loans to help you make the best choice when you need funding.
Overview of Business Loans
Business loans allow you to borrow money that goes directly to your company The funds can be used for any business purpose like
- Starting capital
- Equipment purchases
- Hiring employees
- Marketing campaigns
- Expansion costs
Banks, credit unions, online lenders, and the SBA all offer business loan programs. The most common types are:
- Term loans – You receive the full loan amount upfront and make fixed repayments over a set timeframe.
- Lines of credit – You’re approved for a set borrowing limit and can draw down funds as needed. You only pay interest on what you use.
- SBA loans – Backed by the Small Business Administration. Offer favorable terms but can be time consuming to apply for.
The main benefits of business loans are
- Funds go directly into your business accounts, not personal.
- Your personal assets aren’t collateral for the loan. The business assets secure it.
- Interest payments are tax deductible expenses.
- Establishes business credit history.
The cons are that business loans often require strong personal credit, solid business financials, and collateral. Startups generally have a harder time qualifying.
Overview of Home Equity Loans
Home equity loans allow you to borrow against the equity in your home The funds can be used for any purpose, including financing a business.
With a home equity loan, your house serves as collateral for the loan. The lender places a lien on your home, meaning they can foreclose if you default.
There are two types of home equity loans:
Home Equity Loan – You receive the full loan amount upfront as a lump sum. You make fixed monthly payments over a set repayment term.
HELOC (Home Equity Line of Credit) – You’re approved for a revolving credit line up to a set limit. You can draw down as needed and just pay interest on what you use.
Benefits of using home equity for business financing:
- Quick access to funds
- Interest rates may be lower than business loans
- Can qualify with lower/no business credit
- Good option if business is too new for conventional loan
Downsides are that your home is at risk if you default and you lose tax deductions for interest paid.
Key Differences Between Business & Home Equity Loans
Now that we’ve covered the basics of each loan type, let’s look at some of the major differences between business loans and home equity loans:
Use of Funds
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Business loan funds must be used for company expenses.
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Home equity loan funds can be used for any purpose, personal or business.
Collateral
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Business loans require the business assets to secure the loan.
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Home equity loans use your home as collateral, putting it at risk.
Liability
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With a business loan, the company is liable for repayment.
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A home equity loan makes you personally responsible.
Interest Deductions
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Business loan interest is a tax deductible expense.
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Home equity loan interest is not deductible (exception for HELOCs if under borrowing limit).
Impact on Credit
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Business loans help build business credit profiles.
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Home equity loans utilize personal credit.
Qualification
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Business loans require solid business financials/revenue.
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Home equity loans focus more on personal credit/debt ratios.
Costs
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Business loans typically have lower interest rates.
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Home equity loans may have higher rates.
When to Use Business Loans
Given the major differences between business loans and home equity loans, here are some instances when a business loan is likely the better choice:
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You want to keep personal and business finances separate.
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Your business is established with strong financials to qualify.
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You need a large amount of financing ($100K+).
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You want lowest interest rate possible.
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You don’t want to put your home at risk.
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You want to build business credit history.
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You need flexible loan uses like working capital, equipment, etc.
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You want tax deductible interest.
When Home Equity Loans Make More Sense
Here are situations where a home equity loan/HELOC could be a better option over a business loan:
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You need smaller loan amounts under $100K.
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Your business doesn’t qualify for a conventional loan yet.
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You need very fast financing. Home equity loans fund quicker.
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Your business is still new/startup phase.
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You have significant home equity available to leverage.
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You have great personal credit but limited business credit.
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Your home equity interest rate is lower.
Tips for Deciding Which Loan is Right for You
If you’re still on the fence about whether to use a business loan or home equity loan, here are a few tips:
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Look at loan amount needed – home equity better for under $100K.
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Review all your business and personal qualifications – choose option you qualify for.
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Compare interest rates – go with lower rate.
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Calculate total costs – interest, origination fees, etc.
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Consider risks – business loan lower risk to personal assets.
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Think long term – business loan helps credit profile.
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Talk to a business banker – get expert advice.
The Bottom Line
Access to capital is critical for business growth. While both business loans and home equity loans provide financing options, there are clear differences between the two. In many cases, a business loan is the better, lower risk choice. But home equity loans make sense in certain situations like needing small amounts quickly or not yet qualifying for a conventional business loan. Compare all the factors carefully before making your decision.
How does home equity work?
Home equity is the difference between what you owe on your mortgage and the current value of your home. To calculate your home equity, all you need to do is subtract your remaining mortgage balance from the current value of your home. You build up your home equity by making consistent monthly mortgage payments over the years.
When you borrow against your home equity, you are essentially taking cash out of your house that you must pay back with interest. If your business fails and you can’t pay back your loan, you could lose your house to foreclosure, which is why there are better alternatives to fund the start of your business.
The intended purpose of a home equity loan is typically home renovations or improvements that will increase the value of your property, but they can also be used for other life expenses such as paying off high-interest credit card debt, covering college tuition or building a business.
The two most common types of home loans are home equity loans and HELOCs.
- Home equity loan: A home equity loan provides you with a lump sum of cash at a fixed-interest rate. You receive all of your funds upfront and have predictable monthly payments over the lifetime of your loan.
- HELOC: A HELOC is an open line of credit that functions more like a credit card. You can make withdrawals from your HELOC account as often as you need (you don’t receive your entire loan upfront). HELOCs, however, have variable interest rates that rise and fall depending on economic conditions, so be prepared for your monthly payments to go up and down. With HELOCs, you can typically make interest-only payments for the first 10 years of your loan, known as the draw period, which helps keep your payments low for a while.
Why is a home equity loan an appealing choice to fund the start of a business?
Home equity loans can be a good choice to fund a business venture because they have high limits and long repayment periods, which offers you flexibility when repaying your loan.
- It’s easy to qualify: If you’re a homeowner with at least 15% to 20% equity in your home, good credit and a debt-to-income, or DTI, ratio of less than 36% (but no more than 43%), you should be able to qualify for a home equity loan relatively easily.
- High loan limit: Your loan limit could be much higher than a credit card limit or personal loan as it’s secured by your property. Your loan amount will also depend, in part, on how much equity you have in your house.
- Lower interest rates: Because your home serves as collateral to secure the loan, lenders can offer lower rates for home equity loans compared with credit cards or other types of loans, which are unsecured. Right now, the average rate for home equity loans is 7.77% and average HELOC rates are at 7.31%, according to Bankrate.
- Longer period to repay loan: Being able to repay your loan over a period of 20 to 30 years gives you flexibility in your budget, and keeps your monthly payments lower over time, too.
HELOC Vs Home Equity Loan: Which is Better?
FAQ
Is it better to get a business loan or a home equity loan?
Can a home equity loan be used for business purposes?
What is the monthly payment on a $50,000 home equity loan?
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Loan amount
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Monthly payment
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$25,000
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$166.16
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$50,000
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$332.32
|
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$100,000
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$673.72
|
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$150,000
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$996.95
|
Are business loans worth getting?
How is a home equity loan different from a business loan?
While they’re both forms of financing, a home equity loan differs from a business loan in several ways. A home equity loan or line of credit (HELOC) is a debt that’s secured by your home, similar to a mortgage.
Should I use a home equity loan or HELOC to start a business?
You should avoid using a home equity loan or HELOC to start a business if you have other financing options that don’t involve using your home as collateral. New businesses have a high rate of failure, and risking your home to foreclosure isn’t worth it if you have other alternatives such as a business loan or credit cards.
Is a commercial business loan better than a home equity loan?
Harder to qualify for, commercial business loans also may have higher interest rates than home equity loans. The current average home equity loan interest rate is 8.49 percent ( slightly higher for HELOCs), whereas a $50,000 SBA microloan (tailor made for new small business owners) could run you up to 13 percent interest.
Should small business owners take out home equity loans?
Some small business owners take out home equity loans against their homes instead of business loans. Usually, entrepreneurs opt for home equity loans if their credit isn’t stellar, are just starting their business, or need quick access to cash. Pros: A quick, easy source of cash that can be used for personal or professional purposes.