Raising capital for your business can be difficult, especially for first-time entrepreneurs. This is where being a homeowner comes in handy.
If you own a sizable home outright (i.e. no longer mortgaged), there are various ways to raise capital to start your business. Cash-out refinances, home equity loans, lines of credit, and equity share agreements are all ways to access cash from your home.
However, the disadvantage is that your address becomes collateral when borrowing money. Therefore, if your business fails and you default on your debts, you could lose your home.
Here’s what you need to know about using home equity to invest in your business.
Home Equity Loans vs. Business Loans: What’s the Difference?
Although both are forms of financing, home equity loans differ from business loans in several ways.
A home equity loan or line of credit (HELOC) is a debt secured by your home, similar to a mortgage. Basically, you can borrow up to a certain percentage of your equity (the portion of your home that you own outright, not the mortgage repayment amount).
Insights on bank rates
For example, let’s say your home was purchased for $350,000. You put down $50,000 and took out a $300,000 mortgage. A few years later, your home is valued at $500,000, and you have $200,000 left on your mortgage. That way, you have $300,000 in equity and can borrow up to 80% or 85% of that depending on the lender (in most cases you won’t have full access to the property and will be able to borrow a certain amount) must be maintained at home).
Home equity loans are often long-term, fixed-rate loans of 10 to 20 years (sometimes 30 years). HELOCs typically offer variable interest rates. The types of interest rates offered by banks, credit unions, and mortgage companies take into account your personal financial situation, including your credit score, income, and debt.
In contrast, a business loan is a loan made to a (new) company or enterprise. They can be secured or unsecured, but in the former case, assets or other things related to the business usually act as collateral. Funds can be received in a lump sum, but business lines of credit also exist.
Although terms can vary widely, small business loans tend to have shorter terms than home equity loans. A strong personal and business credit history, including a credit score, or (for startups) a strong business plan/forecast for revenue is often required. Loan repayments must be made from business income. Commercial business loans and lines of credit may also have higher interest rates than home equity loans. The current average interest rate on home equity loans is 8.39 percent (slightly higher for HELOCs), while $50,000 SBA microloans (customized for startups and fledgling businesses) have interest rates of up to 13 percent. It may take some time.
How can I leverage my home equity to invest in my business?
There are several ways to use your home equity to fund your business idea. Here are some of the most common ones.
cash out refinance
A cash-out refinance mortgage is a new, larger mortgage that replaces your current home. You can receive the difference between the two loans in cash.
How much cash you have access to depends on the equity you have in your home. You may be able to change the terms of your mortgage, such as the repayment period and interest rate.
Advantages of using cash-out refinancing
- Avoid adding a second lien on your home
- You can redefine your current mortgage terms
- If you combine monthly payments with mortgage payments and loan payments.
Disadvantages of using cash-out refinancing
- A lengthy application process (similar to taking out a first mortgage)
- Depending on current interest rates, your monthly mortgage payments could be higher
- You must pay closing costs and other fees
Home Equity Loans and HELOCs
A home equity loan is a fixed-rate loan that allows you to borrow a specific amount in a lump sum payment. Unlike a cash-out refinance, a home equity loan does not replace your original mortgage. Instead, it becomes a second lien on your property. In fact, these loans are often known as second mortgages.
A home equity line of credit (HELOC) is a revolving line of credit with a variable interest rate that increases and decreases over time. Unlike a home equity loan, a HELOC lets you use the funds to pay it back and borrow again, just like a credit card.
You can borrow money during a so-called lottery period, often for 10 years. After that, the HELOC repayment period begins again. You will no longer be able to withdraw your funds and will only be able to repay your debt. This period typically lasts up to 20 years.
Your home is the security for your loan, so if you fail to repay your home equity loan or HELOC, you could end up in foreclosure.
Advantages of using a home equity loan or HELOC
- Repayment period is long. For HELOCs, the option to initially repay interest only
- Relatively easy application procedure
- Pay interest only on the amount you actually withdraw (HELOC)
- Possibility of tax deduction of loan interest (if the funds are used at home, for example to build an addition for a business)
Disadvantages of using a home equity loan or HELOC
- If you default, your home is at risk.
- HELOC repayment amounts may change due to changes in interest rates
- If the value of your home declines, you may end up owing more than your home is worth.
Stock split agreement
Another way to access shares is to enter into a share sharing agreement. This is more of an investment than a loan. A share-share company pays you a portion of your home’s future value and is repaid when the contract expires or when you sell your home. Essentially, the company will own equity in your home. The exact arrangement varies, but typically the initial investment plus a percentage of the home’s value is returned at payback.
Home equity sharing agreements often have lower credit and income standards than refinances, home equity loans, and HELOCs. They are often targeted at people who don’t qualify for traditional loans. Unlike a home equity loan, there are no monthly payments or interest charged when you enter into an equity share agreement, which is useful if your cash flow is being spent on a new business, and the funds are paid out in a lump sum.
Benefits of using a stock split agreement
- No monthly principal or interest repayments required
- Often easier to qualify for than a home equity loan or refinance
- Repayment period is long
Disadvantages of using a stock split agreement
- You may not receive as much funding
- Large lump sum repayment required
- You could probably end up paying back much more than you received or would have paid in loan interest
How to fund your business with home equity
Turning capital into cash and starting a business requires some planning. The requirements are less stringent and the process less onerous than for a business loan, but approaching your application with a strategy and an idea of what to expect will set you up for success.
1. Plan your business.
Technically, you don’t need to submit a business plan to convert your stock into cash, but you need to know how you’re going to build your business, what your target audience is, what your overhead will be, and how you’ll make a profit. We recommend that you outline how you plan to increase your income. . This will help you know how much you need and when you can pay it back.
2. Research options and providers
When deciding how to finance your business, consider how to cash out each stock. Different home equity valuation methods have different advantages and disadvantages for starting a business. For example, a HELOC can provide more flexible cash flow than a lump sum from a refinance or equity loan.
The interest rate you get will affect how much you end up paying back, so make sure your credit is strong so you can choose the best rate.
3. Check requirements
All cash-out loans and home equity loans have minimum equity and credit scores. Many financial institutions require you to leave around 20 percent of your equity intact and can borrow up to 80 percent (some will lend you up to 90 percent). Credit scores and income requirements vary, but are typically in the mid-600s for home equity loans, refinances, and HELOCs.
4. Consider repayment methods
Repaying loans is an essential part of your business and long-term financial planning, and one of the challenges when starting a small business.
Depending on the method you choose, you may have to pay off your loan immediately. This can be a problem if you don’t turn a profit quickly. Make sure you have a way to make your monthly payments even if your monthly payments are slow. With a home equity contract, payments are made when the home is sold or the contract ends, so you don’t have to make monthly payments. However, be careful as you will end up paying a lot of money.
5. Gather the necessary documents
Depending on the method you choose, you’ll need to provide your credit score, home ownership, and tax documents to your servicer. Some banks allow you to apply online. In some cases, you may need to apply directly.
6. Apply and wait
Please apply when you are ready. Your servicer may pre-qualify you for a certain amount to provide a benchmark for the cash you will receive. You will also need to undergo a home appraisal to determine the value of your home, along with other application requirements. Depending on the method, it can take weeks or months to receive your money.
