Using Home Equity to Start a Business
The United States is home to many of the world’s most successful entrepreneurs, producing a steady stream of new businesses and entrepreneurs each month. For example, in April 2022 alone, according to the United States Census Bureau, business start-up applications totaled over 420,000.
But as many entrepreneurs will tell you, the path to self-employment can be very challenging. One of the many challenges new entrepreneurs face is how to raise money to fund their business. Traditional options include small business loans, personal savings, or loans from friends and family. However, with real estate prices increasing significantly in recent years, many entrepreneurs may be tempted to look to home equity as a source of business financing.
The central theses
- It is possible to use home equity as a source of funding for a new business.
- This can be done through cash-out refinancing, home equity loans, or home equity lines of credit (HELOCs).
- There are pros and cons to using home equity for business purposes.
Using Home Equity for Business Financing
The average home price in the United States increased by almost 80% between Q1 2012 and Q1 2022. Because home equity is the difference between the current market price of a home and its outstanding mortgage debt, many Americans have seen their home equity increase with this rise in home prices. For homeowners in this favorable position, there are several ways you can use your home equity as a source of cash.
Of course, the easiest way to raise cash from your home equity is to sell your home. If you take this approach, your sale proceeds will be approximately equal to your home equity minus any applicable taxes and closing costs. On the other hand, there are also ways to extract cash from home equity while retaining ownership of your home. For example, you could do a cash payout refinance or purchase a home equity loan or line of credit (HELOC).
Cash Out Refinancing
As the name suggests, a cash-out refinance is a type of mortgage refinance transaction that gives you a lump sum of cash. It usually works by replacing your mortgage with a new mortgage at a time when your home equity has increased since you got your first mortgage. Homeowners in this scenario can then use the new mortgage to pay off their original mortgage and pocket the difference.
To illustrate, consider a scenario where you bought a house for $200,000 and secured a mortgage for 80% of the house price, or $160,000. A few years later, the home is valued at $300,000. In this scenario, the bank could allow you to refinance with a new mortgage worth 80% of the current market price, or $240,000. In this scenario, you would pay off the previous mortgage and be left with $80,000 in cash. In practice, your actual cash earnings would be less as you would have to cover closing costs. In addition, your income and credit rating would still need to be eligible for the new mortgage.
Home equity loans and HELOCs
If refinancing is not an available or attractive option for you, another approach is to take out a traditional home equity loan. Like a cash-out refinance, home equity loans offer a lump sum cash payment and typically come with relatively cheap fixed interest rates and fixed repayment schedules. You are secured from your home, so it is very important not to miss any payments.
Another option would be to get a home equity line of credit (HELOC). These loans act as revolving lines of credit, allowing you to withdraw funds on a schedule of your choosing, rather than receiving the entire loan proceeds at once. HELOCs also allow you to only pay the interest on the loan, which allows you to minimize your monthly payments. While traditional home equity loans have fixed interest rates, HELOCs come with variable interest rates, meaning you’re at greater interest rate risk. Although HELOCs offer a great deal of flexibility initially, they automatically require scheduled principal repayments after an initial period — often between five and ten years — known as the draw period.
Advantages and disadvantages
As with most things in finance, there are pros and cons to each of these approaches. The main benefit of using home equity to start a business is that it is much more accessible while offering lower interest costs. Applying for a traditional small business loan can often be a challenging process, as many lenders are reluctant to extend capital to an unproven business. “Banks will only sell you an umbrella if it doesn’t rain” is a common saying among entrepreneurs. In other words, they’re happy to lend money to your business, but only if it’s already successful and doesn’t need the funds.
Although relying on home equity loans can help circumvent this problem, it is not without its risks. After all, there’s a good reason why banks are reluctant to lend money to new businesses. With about 20% of new businesses failing in their first year and 65% in their first decade, there’s no denying that real credit risk exists. And since investing in equity puts your home at risk, entrepreneurs should carefully consider whether to take the risk. To be clear, using home equity to start your business means that if your business fails, you could potentially lose your home as well.
Can you use an owner-occupied home as security?
Yes, you can use the owner-occupied home as security. For example, when you take out a home equity loan or HELOC, your home is pledged as collateral for the loan. This means that if you fail to make your payments, the lender could terminate you and take ownership of your home.
Can I start a business with no money or collateral?
Yes, it is possible to start a business with no money or collateral, although whether it is possible or worthwhile will of course depend on your specific risk tolerance and circumstances. For example, an entrepreneur might start a business by selling equity to outside investors, receiving government grants, or relying on money from friends and family. Entrepreneurs who are in financial difficulties often refrain from paying themselves a salary until their company is financially self-sufficient.
What type of home equity loan allows you to get a lump sum?
A cash-out refinance or a traditional home equity loan both offer a cash payment at the time of borrowing. A HELOC could also be used in this way where you could decide to withdraw the entire balance of the loan right away. Keep in mind that you could be exposed to significant interest rate risk, particularly in the case of HELOCs.
The final result
If, despite these risks, you think using home equity is still your best option, there are some additional steps new entrepreneurs can take to manage their risk. The first thing to remember is that, in general, not all business ventures are created equal. By surveying the industries and entrepreneurs in your area, you can find that certain types of businesses have a better chance of surviving than others. In addition, some uses of capital within a given company may be more risky than others. For example, inventory that is at risk of redundancy or spoilage may be at greater risk than inventory that retains its value indefinitely with limited risk of damage or depreciation.
Regardless of how you fund your new venture, it generally pays to do extensive due diligence on your industry and your competitors, and create a detailed budget that you can use to plan and get your money. Seeking input from trusted advisors, such as B. experienced entrepreneurs in your region or selected industry, can also help you to maximize your chances of success.