Starting a business is possible without a large upfront investment. In fact, a third of small businesses launch with less than $5,000, and 58% start with less than $25,000. But staying in operation is where expenses tend to run up, as 60% of small businesses do not operate profitability in the early years.
Because early-stage businesses are rarely profitable, business owners may have to get creative when funding the endeavor. This leaves many wondering how to get money to start a small business. For those who are homeowners, taking out a home equity line of credit (HELOC) to keep the business afloat is a possibility.
But is it a smart idea to use HELOC for business? Why not apply for a business loan? HELOCs are primarily used for home improvement, debt consolidation, emergencies, and long-term investments. There are even investors that use HELOC on a vacation home. But for business? What are the benefits, drawbacks, and things you need to know? Let’s dive in.
What is a HELOC?
A home equity line of credit allows you to borrow money against the value and equity of your home. Instead of borrowing money against your business, you can leverage your home’s capital. In effect, it’s similar to taking out a second mortgage on the house. But there are some crucial differences between the two.
Unlike a second mortgage, a HELOC functions like a revolving line of credit—funds are drawn as needed and not in a lump sum. For example, if you have a $200,000 HELOC, you can borrow up to that figure according to the given adjustable interest rate. Should you only use a percentage of that $200,000, you will only pay interest on what was used, not on the entire value of the loan.
Because the home is used as collateral for the loan, the interest rate is lower than a credit card. However, if you default on the loan, the lender can foreclose on the house. As a result, the borrower can decide where to direct the funds. And a common use is starting a business and business purposes.
How to Use HELOC for Business Purposes?
Home equity lines of credit are readily available to small-business owners. Many opt for this type of funding when their credit score isn’t high enough for a big bank loan, they don’t have much working capital or don’t want to give up a percentage of the business to private equity investors.
Applying for a HELOC is a straightforward process. And since the funds are unmonitored, you have the flexibility to direct them where you want. That said, there are some requirements, including:
- You must have at least 15%–20% home equity – Lenders determine your loan-to-value (LTV) ratio to see the difference between what you owe on the house and the home market’s value. This figure is calculated by dividing the current loan balance by the appraised value of the home.
- How much you can borrow is limited – LTV also impacts how much you can borrow; usually, you’re limited to less than 85% of the home’s value.
- You need a decent credit score – Although you don’t need a prime credit rating, you’ll typically need a mid-600s credit score to qualify. This can make it difficult if you need a HELOC with bad credit.
- Your debt-to-income ratio is a major factor – Although it depends on the lender, the vast majority of HELOC lenders want a borrower to demonstrate that their monthly debts consume less than 43% of their gross monthly income.
- You need to demonstrate steady income – Once more, the lender you work with may look at your income to confirm that you make enough money to repay your loans.
What terms you get depends on your home’s value and home’s equity, and the size of the loan, among other factors. Before you acquire a HELOC, you must consider both the benefits and drawbacks of this type of loan.
Is it Wise to Use a HELOC for your Business?
The question here is not so much about whether you can use HELOC for business purposes as to whether you should?
To help you with that major decision, let’s review the pros and cons.
Benefits of a HELOC Used for Business Purposes
Reasons why businesses apply for HELOC include:
- Flexibility – Unlike other business loans, you have greater freedom and flexibility on what to do with the funds. They could be used to pay for equipment, hire workers, expand, franchise, or buy another location.
- Current market conditions – As of now, home prices are at record highs, and interest rates are at historic lows. Now is an optimal time for business owners to apply for a HELOC because the terms will be more favorable.
- Low-cost loans – Upfront, these types of loans are considered low-cost. The only debt that needs to be paid with interest payments.
- Large amounts available – Depending on how much of your home equity you own, you may be able to borrow large amounts against the home—up to 85% of its combined LTV.
Drawbacks of a HELOC Used for Business
Not everyone can qualify for a HELOC. For instance, you need to demonstrate an income stream. But that can be difficult with a budding business. Similarly, you also must have a respectable FICO score.
But the primary reason why applying for a HELOC may be the wrong decision comes down to risk. In other words, using your personal home as collateral puts you in a perilous financial position. Should the business fail, it could completely devastate your personal finances—you could lose both your business and your home in one fell swoop.
HELOC loans should be viewed as a loan of last resort since stacking debt atop a mortgage puts you at significant risk.
HELOC Alternatives for Business Purposes
HELOC is an option for budding entrepreneur-homeowners, but it’s not necessarily the best option. Here are some alternatives you can consider:
- Personal loan – These are typically unsecured, meaning the lender can’t simply seize your assets. Rates for personal loans may range from 5% to 30%, depending on your income, credit rating, debt-to-income ratio. Per BankRate, the average rate is 11.79%, and loan length ranges from 1-5 years.
- Small-business credit card – Business lines of credit can be acquired on a secured or unsecured basis. Naturally, interest rates vary between the options. But with either path, you only borrow what you need at the time.
- Sale-leaseback – A sale-leaseback provides an alternative solution for modern homeowners, particularly those with low credit scores, little income, or other issues that might preclude them from obtaining a HELOC. Sell your home, lease it back, and convert your home’s equity to cash. This is ideal for borrowers wary of foreclosure because this home equity loan alternative allows you to use your home’s equity without dealing with lenders.
Sale-Leaseback Program for Your Business
Historically, HELOC has been a tool used by home/business owners to convert home equity into a revolving line of credit. But a sale-leaseback solution may be a safer avenue for business owners that want to leverage their home’s value.
Want to learn more? Consult a financial advisor to learn more.
Are you starting a business? How can you get money for your new start-up? HELOC is one of the ways to get money for your business. If you are still unsure of solutions for obtaining this money, after reading this article, consult a financial advisor to discuss your options.
- Small Biz Trends. Startup Statistics. https://smallbiztrends.com/2019/03/startup-statistics-small-business.html
- Debt.org. Home Equity Line of Credit (HELOC). https://www.debt.org/real-estate/mortgages/home-equity-line-of-credit/
- Forbes. The Pitfalls Of (And Alternatives To) Taking Out A HELOC For Your Business. https://www.forbes.com/sites/forbesfinancecouncil/2019/12/04/the-pitfalls-of-and-alternatives-to-taking-out-a-heloc-for-your-business/?sh=2c92765c8828
- Bankrate. The pros and cons of using a HELOC for business, plus alternatives. https://www.bankrate.com/home-equity/use-heloc-for-a-business/
- Bankrate. 7 reasons to use home equity. https://www.bankrate.com/home-equity/reasons-to-use-home-equity/