Using Home Equity to Start a Business

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The United States is home to many of the most successful entrepreneurs in the world, producing a steady stream of new businesses and entrepreneurs every month. According to the United States Census Bureau, for example, new business applications totaled more than 420,000 in April 2022 alone.

But as many entrepreneurs will tell you, the path to self-employment can be very difficult. One of the many challenges new entrepreneurs face is how to raise funds to fund their business. Traditional options include small business loans, personal savings, or loans from friends and family. But with the substantial rise in house prices in recent years, many entrepreneurs might be tempted to look to their home equity as a source of funding for their business.

Key points to remember

  • It is possible to use home equity as a source of financing for a new business.
  • This can be done through cash refinancing, home equity loans, or home equity lines of credit (HELOC).
  • There are pros and cons to using home equity for business purposes.

Use of home equity for business financing

The average price of a home in the United States has increased by almost 80% between the first quarter of 2012 and the first quarter of 2022. Since home equity is equal to the difference between a home’s current market price and its outstanding mortgage debt, many Americans have seen their equity rise alongside this increase in home prices. For homeowners in this favorable position, there are several ways to use the equity in your home as a source of cash.

The easiest way to raise money from your home equity is, of course, to sell your home. If you take this approach, the sale proceeds would be roughly equal to the equity in your property less applicable taxes and closing costs. On the other hand, there are also ways to extract money from your home equity while retaining ownership of your home. For example, you can undertake a cash refinance or acquire a home equity loan or home equity line of credit (HELOC).

Refinancing by withdrawal

As the name suggests, a cash-out refinance is a type of mortgage refinance transaction in which you receive a lump sum of cash. It usually works by replacing your mortgage with a new mortgage, at a time when the equity in your home has increased since the days of your first mortgage. Homeowners in this scenario can then pay off their original mortgage with the new mortgage, pocketing the difference.

To illustrate, consider a scenario where you bought a house for $200,000 and got a mortgage for 80% of the price of the house, or $160,000. A few years later, the house appreciates in value to $300,000. In this scenario, the bank might allow you to refinance using a new mortgage worth 80% of the current market price, or $240,000. In this scenario, you would pay off the previous mortgage and end up with $80,000 in cash. In practice, your actual cash proceeds would be less than this, as you will need to cover closing costs. In addition, your income and creditworthiness will still need to qualify for the new mortgage.

Home equity loans and HELOCs

If refinancing is not an available or attractive option for you, another approach would be to take out a traditional home loan. Like a cash refinance, home equity loans offer a lump sum cash payment and usually come with relatively inexpensive fixed interest rates and fixed amortization schedules. They are secured by your domicile, 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 work like revolving lines of credit, allowing you to withdraw funds on a schedule of your choice rather than receiving all of the loan proceeds at once. HELOCs also allow you to pay only the interest on the loan, allowing you to minimize your monthly payments. While traditional home equity loans carry fixed interest rates, HELOCs come with variable rates, which means you’re more exposed to interest rate risk. Although HELOCs initially allow a high level of flexibility, they automatically begin to require scheduled principal repayments after the end of an initial period – often set between five and ten years – known as the drawdown period.

Advantages and disadvantages

As with most things in finance, there are pros and cons to each of these approaches. The main advantage of using home equity to start a business is that it can be much more accessible while offering lower interest costs. Applying for a traditional small business loan can often be a difficult process, with many lenders reluctant to extend capital to an unproven business. It’s a common adage among entrepreneurs that “banks only want to sell you an umbrella when it’s not raining.” In other words, they are happy to lend your business money, but only when it has already been successful and does not need funds.

Although the use of home equity loans can help circumvent this problem, it is not without risks. After all, there’s a good reason banks are hesitant to lend money to new businesses. With approximately 20% of new businesses failing in their first year and 65% failing in their first decade, there is no denying that there is real credit risk. And since relying on home equity means putting your own home at risk, entrepreneurs should carefully consider whether this is a risk they are willing to take. To put it plainly, using the equity in your home to start your business means that if your business goes bankrupt, you could also lose your home.

Can you use the equity in your home as collateral?

Yes, you can use the equity in your home as collateral. When you take out a home equity loan or a HELOC, for example, your home is pledged as collateral for the loan. This means that if you don’t meet your payments, the lender could foreclose on you and take possession 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 of course this depends on your risk tolerance and situation. For example, an entrepreneur might start a business by selling stock to outside investors, receiving government grants, or relying on money from friends and family. Cash-strapped entrepreneurs will also often refrain from paying themselves a salary until their business becomes financially self-sufficient.

What type of home equity loan allows you to receive a lump sum?

A cash refinance or a traditional home equity loan both offer a lump sum cash payment at the time the loan is taken out. A HELOC could also be used in this way, in that you could choose to withdraw the entire loan balance immediately. Keep in mind that, in the case of HELOCs in particular, this could expose you to significant interest rate risk.

The essential

If, despite these risks, you feel that using your home equity remains your best option, new entrepreneurs can take some additional steps to help them manage their risks. First of all, it should be considered that, generally speaking, not all business ventures will be equally risky. By surveying industries and entrepreneurs in your area, you can determine that certain types of businesses have a better chance of survival than others. Also, within a given business, some uses of capital may be more risky than others. For example, inventory at risk of redundancy or deterioration may be more risky than inventory that will hold its value indefinitely with limited risk of damage or depreciation.

Whichever way you choose to finance your new business, doing a thorough due diligence on your industry and competitors and preparing a detailed budget that will allow you to plan and preserve your money is usually well worth the time. Seeking the advice of trusted advisors, such as experienced entrepreneurs in your area or chosen industry, can also help you maximize your chances of success.

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