Are you ready to launch a new business, but don’t know to fund your idea? Or are you a small business owner ready for expansion who lacks the capital you need to grow?
Sure, small business loans are an option, but simply owning a business — or hoping to start your own business — doesn’t automatically qualify you for this type of financing. A lack of business credit history, a short time in business, or low revenue may prevent you from getting a small business loan. Even if you do qualify, you might get stuck with short terms and high fees and interest rates.
Don’t give up hope just yet, though. If you own your own home, there could be another funding option you’ve not yet considered: obtaining a home equity loan for business purposes. You can leverage the equity in your home to get lower rates, longer repayment terms, and higher borrowing limits than you might with small business lenders.
Sounds great, doesn’t it? Unfortunately, not everyone will qualify for a home equity loan. Others may find that a small business loan, personal line of credit, or another form of funding is better suited for their capital needs. However, if you’re looking for a creative way to finance your startup or expansion plans, read on to learn more about home equity loans and if one is right for you.
What Is A Home Equity Loan?
A home equity loan is also known as a second mortgage. To understand a home equity loan, let’s first take a look at equity. As you pay down the balance of your mortgage, you build up equity. Equity is the difference between what is owed on the home and the value of the property. For example, let’s say your home is valued at $500,000. If your first mortgage has a remaining balance of $200,000, then the equity in your home would be $300,000.
Another way to look at equity is that it is the portion of the home that you own. With a home equity loan, you can use your equity as collateral for an additional loan. If you don’t have equity in your home — that is, the value of your home doesn’t surpass the amount owed on your first mortgage — you will not qualify for this type of loan. Generally, you can expect to receive about 80% to 85% of the value of your home as a lump sum, less the amount still owed on your first mortgage. This money can be used to fund large purchases for your business, including startup costs, new equipment, facility upgrades, or purchasing commercial property.
After receiving your funds, you’ll repay the loan over a longer period of time — usually 5 to 15 years. Home equity loans come with fixed rates and are repaid on a monthly basis.
Equity Loans VS HELOCs
Another type of funding that uses the equity in your home is a home equity line of credit, or HELOC. Similar to an equity loan, a HELOC uses the equity in your home as collateral. However, instead of receiving a lump sum, you get access to a line of credit that you can use for business purposes.
After being approved for a HELOC, you’ll be able to withdraw funds up to and including the credit limit set by your lender for a set period of time — typically a year. When this draw period is over, you’ll enter the repayment phase. At that time, you’ll begin to repay the amount of money borrowed (plus interest). Once you’ve repaid borrowed funds, you’ll be able to borrow funds again.
Most HELOCs come with variable interest rates, whereas most home equity loans have fixed rates. While this provides stability, often you’ll find that home equity loans have a higher interest rate than HELOCs.
If you have a larger purchase to make, such as buying equipment or purchasing real estate, the lump sum offered through a home equity loan is the wiser choice. If you want a more flexible funding option for working capital, hiring new employees, or purchasing inventory, a HELOC may be the better option for your business.
Equity Loans VS Business Loans
A home equity loan is similar to a business loan in a few ways. With both types of funding, you receive a lump sum that can be used to fund your business purchases. Many small business lenders also offer low, fixed rates, long repayment terms, and monthly repayment schedules.
However, there are also a few distinct differences. With a home equity loan, the equity in your home serves as the collateral for the loan. For business loans, other forms of collateral may be used, including business equipment or real estate. You may also be required to sign a personal guarantee or agree to a blanket lien.
Borrower requirements also differ. When you apply for an equity loan, the lender will consider factors including your personal credit profile, your debt-to-income ratio, and the amount of equity in your home. Small business lenders may consider factors including personal credit, business credit, annual revenues, and time in business.
When Should Merchants Use A Home Equity Loan?
Each business is unique, which is why one source of funding doesn’t work for everyone. However, there are many small business owners that will find that a home equity loan is a viable way to access capital.
If you haven’t yet opened the doors to your business because of startup costs, a home equity loan may work for you. No time in business, business revenue, or business credit history is required to qualify.
A home equity loan may be a good choice for you if you want a low-cost loan option. If you’ve shopped around for other financial products and aren’t satisfied with short terms, high interest rates, excessive fees, or repayment schedules, a home equity loan could give you the affordable capital you’re looking for. You’ll receive a low fixed rate and a longer period of time to repay your loan. You may even qualify for additional savings if you work with the lender of your first mortgage.
However, there are also times when maybe a home equity loan isn’t the best fit. If you have an established business and a solid personal credit profile, you could qualify for other types of funding such as Small Business Administration loans. These loans come with low interest rates, repayment terms up to 25 years, and are easier to qualify for than traditional bank loans.
You may also explore additional funding options if you need more specialized financing. For example, if your business needs new equipment, equipment financing may be a better option. You could potentially qualify for low rates and favorable terms without putting your personal assets on the line. With equipment leases, you can even turn in your equipment and enter another lease for new equipment — a smart idea if you need to upgrade frequently.
Finally, a home equity loan won’t work for borrowers with a poor credit score or a spotty credit history. Most lenders look for a good credit score in the 700s, although some may work with fair credit borrowers. However, borrowers with lower scores frequently need more equity, a lower DTI, and must meet other requirements to qualify. Your application may also be declined if you have a recent bankruptcy or foreclosure, defaults on past loans, or other negative items on your credit report.
Home Equity Loans For Business: Pros & Cons
By now, you should have a good understanding of what a home equity loan is, how it can help your business, and what you need to qualify. If you’re still on the fence about submitting an application, consider these pros and cons before making your decision.
- Low Interest Rates: Low interest rates mean that your cost of borrowing is lower. You could save thousands of dollars in interest by taking out a home equity loan versus other types of funding.
- Long Repayment Terms: Most home equity loans have repayment terms of 5 to 15 years, although this varies by lender. With a longer repayment term, you can stretch out the cost of your business expenses through easy, manageable payments.
- Startup-Friendly: Since factors like time in business aren’t a consideration for approval, startups and new business owners may qualify when other lenders turn them down.
- Flexibility: You aren’t restricted in how you use the funds from your home equity loan.
- High Borrowing Amount: Depending on the amount of equity you’ve built up in your home, you could qualify for a larger sum of money than other lenders offer you.
- Risk Of Losing Your Home: If you pay your home equity loan as agreed, you won’t have any problems. However, if you default on your loan, you risk losing your home.
- Fees: There are associated costs and fees with taking out a home equity loan, so be prepared. This may include application fees, closing costs, and prepayment penalties for paying your loan off early.
- Going “Upside Down”: If the value of your property drops after taking out a home equity loan, you risk being “upside-down” on your loan. This means that you owe more than the property is worth.
Alternatives To Home Equity Loans
Still undecided if a home equity loan is right for you? This funding certainly isn’t for everyone, and you may find that another financial product is better suited for your needs. Before taking the leap into a home equity loan, consider these alternatives and whether one may be right for you.
Business Lines Of Credit
With a business line of credit, you’ll have access to funds that you can use as needed. Your lender will set a credit limit, and you can make draws up to this credit limit. As a form of revolving credit, your funds become available to use as you pay off the borrowed amount, giving you continuous access to cash when you need it.
If you need access to cash on-demand, a business line of credit may be a more suitable choice than the lump sum offered through a home equity loan. You may also consider a business line of credit if you don’t own your own home or don’t have enough equity.
This may also be an option for borrowers with a poor credit profile, as some lenders may consider the performance of your business when approving your application. However, if you don’t meet time in business or revenue requirements, your application will be declined. You’ll also find that many business lines of credit have higher rates and fees and shorter terms than home equity loans.
If unpaid invoices are causing cash flow issues, consider invoice financing. With this service, you’ll receive a portion of the outstanding funds upfront — usually 80% to 90% of the invoice total. Once the invoice is paid, you’ll receive the remaining funds, less any fees charged by the lender. Your invoices serve as the collateral.
This is an option typically available to B2B and B2G businesses. You may also have to meet other requirements in terms of revenue, time in business, and the quality and quantity of invoices. Invoice financing is a great way to get access to cash. However, be aware that this can be an expensive form of borrowing depending on the factor rate assigned by your lender. This is also a short-term solution, so if you need longer repayment terms, consider applying for a home equity loan or another financial product.
Business Credit Cards
If you have recurring expenses that require a more flexible form of funding, consider applying for a business credit card. With a business credit card, you can make as many purchases as you need up to your assigned credit limit. Qualifying for a business credit card is fast, and you can begin using your card immediately without waiting for further approval from the lender.
You may even consider applying for a rewards card, which scores you cash back or points to apply toward rewards like travel, shopping, and more.
High interest rates are a drawback of some business credit cards. For larger purchases, another form of funding may be more affordable.
Small Business Administration (SBA) Loans
Small Business Administration (SBA) loans offer high borrowing limits and low interest rates to fund business expenses. SBA loans have similar rates and terms to traditional bank term loans. However, these loans are backed by the government, making it easier for small business owners to qualify.
There are many different types of SBA loans, from smaller microloans to the popular SBA 7(a) loans that provide up to $5 million repaid over a period of up to 25 years.
In order to receive an SBA loan, factors including time in business and personal credit history will be considered. The process for receiving an SBA loan is lengthy and can take 30 days or longer from application to funding. However, this may be a great alternative if you don’t own your own home or don’t have enough equity to qualify for a home equity loan.
A home equity loan certainly has its benefits — startups can qualify, interest rates are low, and terms are favorable. However, there may be other options that make sense for your business. As with any other loan, shop around your options, compare lenders, and understand the terms of your loan before signing a contract.
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