It is a thrilling experience full of challenges, opportunities and challenges. But to do so requires money. You can use a home equity line of credit to fund your small business. But you must understand the advantages and disadvantages.
As property values have soared across the nation in the last two years, home equity loans are becoming more popular. Home equity loans, also known as HELOCs or home equity lines of credits, have been used at the highest level since 2007. However, they are still a risky method to fund new businesses.
Danny Papadopoulis is a Mortgage Broker with the Home Equity Loan specialists at Homebase Mortgages based in Toronto. He says that even entrepreneurs who achieve success in their business are at risk of failure. Do you want to rely on your roof, your home?
What Is Home Equity?
Home equity is calculated as the difference between the amount you owe for your mortgage and the value of your house today. You can calculate your home equity by subtracting your mortgage balance from your current home value. Your home equity is built up by consistently paying your mortgage over time.
If you borrow from your home equity you are taking money out of your home that you will have to pay back, plus interest. You could lose your home if you fail to pay back the loan and your business fails.
Home equity loans are typically used to renovate or improve your home, increasing the value of it. However, they can be used for other expenses, such as paying down high-interest debt on credit cards, covering college tuition, or starting a new business.
Home equity loans and HELOCs are the two most popular types of home loan.
Home Equity Loan: An equity loan is a lump-sum of money that you receive at a fixed interest rate. You will receive your entire loan amount upfront, and you can expect to make predictable monthly payments for the duration of your loan.
HELOC: An open line of credit, a HELOC works more like a card. You can withdraw money from your HELOC as many times as you like (you do not receive the entire loan up front). HELOCs have variable interest rates, which can rise or fall depending on the economic climate, so you should be prepared to see your monthly payments fluctuate. HELOCs allow you to make only interest payments during the first ten years of the loan. This is known as the “draw period”, which keeps your monthly payments low.
What Makes A Home Equity Line Of Credit A Good Option For Funding The Start-Up Of A New Business?
Home equity loans are a great way to fund your business because of their high limits and long payment periods. This gives you more flexibility in repaying the loan.
You can qualify easily: As long as you have a good credit score, a debt to income ratio (DTI) of less than 36%, and a DTI ratio between 35 to 43%, you will be able qualify for an equity loan.
High Loan Limit: Your property could secure a much higher loan limit than your credit card or personal loan. The amount of your loan will be determined in part by the equity in your home.
Lower rates of interest: Because your home is used as collateral, lenders are able to offer lower rates on home equity loans than they can for credit cards or other unsecured loans. According to Bankrate, home equity loan rates average 7.77%, while HELOCs average 7.31%.
Loan repayment period: You can repay your loan for a longer period, allowing you to have more flexibility with your budget. Your monthly payments will also be lower.
Why A Home Equity Line Of Credit Is A Risky Way To Start A Business
A recession could be on the horizon, and it’s not a good idea to use your home as collateral for a business that may yield unpredictable results. Home equity loans are less attractive as the rates have risen in the last year.
AJ Makkunel, a Home Equity Loan Specialist with Mortgage Central Nationwide warns that home equity loans are no longer an affordable source of funding. He notes that HELOC interest rates have reached their highest levels in 15 years. McBride notes that the variable rate will likely increase as the prime rate increases above 7%. “The cost of borrowing is higher than we are used to and economic uncertainty is also greater.” He says that’s a bad combination.
There are several reasons why a home equity line of credit is not a good idea for starting a new business.
You put your home at risk: This is the most dangerous option for financing. Why risk your home when you can get high credit limits with a personal loan or business card?
Borrowing against home equity does not build business credit: Just like personal credit and the ability to repay a loan, business credit measures your business’s creditworthiness.
To qualify for the lowest rates, you need to have exceptional credit: If your credit score is not exceptional (FICO 800-850), or you do not have very good credit (740-799), a home equity mortgage may actually cost you more money. The best rates are available only to homeowners who possess exceptional credit. You should ensure that the terms and rates you lock in for a home equity are better than those you could get from a personal loan or credit card. If you don’t, it is not worth risking your roof.
HELOC rates of interest are variable: In a rising rate environment such as we are in today, variable rates will not benefit you.
A Case Study: Urban Tail Toronto Dog Walkers
Lori Blair owns Urban Tail Toronto dog walkers, and opted for a home equity loan to fund her business a few years ago. “I looked at different business loans, personal loans and even a business credit card, but from my point of view, a home equity loan made the most sense for me”.
Since getting her loan, Lori has built her business into one of Toronto’s most successful dog walking and pet services business with locations throughout downtown Toronto.
“For me, a home equity loan was a real game changer. It allowed me to take the equity I’ve built in my home over the years and put it to work, helping my business grow exponentially over the last 3 years. It’s been one of the best business decisions I’ve made”.
The Bottom Line
If you can find other ways to finance your business without using your house as collateral, then it’s best to avoid a HELOC or home equity loan. If you’re starting a new business, it is likely to fail. Using your home as collateral for a loan or credit card would be a better option.
Daniel is a Cinnamon Hollow author passionate about house and home, renovations, homesteading and DIY.