Should You Use a Home Equity Loan or Line of Credit to Finance Your Business?

Around 25% of small business owners have used a home equity loan (HEL) or home equity line of credit (HELOC) to finance their startup or business, according to Barlow Research. HELOCs can be an inexpensive way to fund a business and are much easier to get than tradition business loans or SBA loans for startups. This article explores the pros and cons of leveraging your home equity for your business and also looks at rates, terms, and qualifications of a HELOC or HEL.

If you’re shopping for a home equity line of credit, you can reach out to one lender at a time hoping you find a good deal. Or, you can visit an online marketplace, like LendingTree, and review offers from multiple lenders at once. Save time, shop smart, and find a HELOC that fits.

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At a Glance: Home Equity Loans and Lines of Credit

*Equity is your level of ownership in your home. It’s calculated by subtracting your remaining mortgage payments from the market value of the home. For example, if you have a $400,000 mortgage and still have to pay ¼ of it ($100,000), your equity in the home is $300,000.

Pros and Cons of using a HEL or HELOC

There are advantages and disadvantages to letting your home equity work for your business.

Pros:

• Inexpensive. HELs and HELOCs are cheaper than bank loans, alternative business loans, credit cards, and virtually every other type of business financing. This is because they are secured by your home, making them less risky for the lender.
• Available for startups. HELs and HELOCs are especially useful for those seeking to start a new business because financing a startup can be very difficult.
• No business collateral needed. A lot of business loans require collateral or a lien on business assets plus a personal guarantee. A HEL or HELOC requires a personal guarantee but your business assets aren’t at risk.
• Flexibility and no restrictions on usage. Some business loans place restrictions on how you can spend the funds. Money from a HEL or HELOC can be spent in any way you like. A HELOC is particularly flexible because you can draw on it whenever you have a shortfall of capital.

Cons:

• Your home is on the line. If you fall behind on payments, you could lose your home.
• Tied to home ownership. Obviously, you can’t get a HEL or a HELOC unless you’re a homeowner. When you sell your home, you must pay off the HEL or HELOC in full with the proceeds of the sale. Selling too early could trigger prepayment penalties.
• Fees and prepayment penalties. Even though interest rates are low, some lenders charge annual fees, origination fees, application fees, or prepayment penalties which add on to the cost of borrowing. With a HELOC, these fees are charged even if you don’t use the funds.

If you don’t want to risk your home, small business credit cards can be easy to qualify for and a cost effective way of financing your startup. Many come with 0% APR introductory periods and valuable cashback or rewards programs. Check out our review of the best on small business credit cards here.

See All Small Business Credit Cards

Home Equity Loans vs. Home Equity Lines of Credit

Home equity loans and lines of credit both allow you to leverage the equity in your home to borrow money for your business, but there are differences between them.

Home Equity Loan

A HEL is a term loan secured by your home and is often referred to as a “second mortgage.” Just like a mortgage, you get a lump sum of capital that you pay back over a fixed period of time. HELs typically have 5-15 year terms and fixed interest rates, so your monthly loan payments remain the same over the life of the loan.

It’s best to use a HEL for the purchase of business assets (e.g. equipment) or for long-term investments. For example, if you need to do $25,000 worth of storefront remodeling, a HEL might be the way to go. Similarly, if you’re using the money to buy out an existing business, a HEL is usually a better option than a HELOC.

Home Equity Line of Credit

A HELOC is a revolving line of credit secured by your home which works similarly to a credit card. You get access to a specific sum of money for a particular period of time (called the “draw period,” typically 5-10 years) and can draw on the money as needed. Just like a credit card, as you pay back what you borrow, you can access those funds again. The nice thing is that you only pay interest on money that you actually use. For example, if you have a $100,000 HELOC but only withdraw $20,000, you’ll only pay interest on the $20,000.  In contrast, you must immediately begin repaying principal and interest on a HEL regardless of when you use the loan funds.

HELOCs typically have a variable interest rate. This means your monthly payments will vary depending on the market rate at the time of the draw and on how much you borrow. Interest rates are historically low at the moment, but if and when they rise, your payments will increase as well. If you want the guarantee of fixed monthly payments, choose a HEL instead.

There are 2 repayment periods for a HELOC. During the initial 5-10 year draw period, you can withdraw funds from your line of credit, and minimum payments go to interest only. During the next 10-20 years, the HELOC becomes like a loan that you pay back, with higher monthly payments going toward principal and interest.

HELOCs are an effective solution for working capital shortfalls and for variable business expenses. For instance, if you need money to buy inventory each month but the expense varies, a HELOC gives you the flexibility to use the amount of money you need when you need it without having to pay interest on unused funds. Similarly, if you need money to cover operating costs during seasonal slowdowns or while waiting for customers to pay you, a HELOC can come in handy.

The downside to a HELOC is that it can be taken from you. If your home value falls significantly or you fail to make timely payments, the lender can freeze your HELOC. This is not possible with a loan, though the lender can report you to credit bureaus or initiate proceedings against your home if you don’t make loan payments for 30 days or more.

If you’re considering tapping into their property’s equity, take a look at LendingTree. Their online marketplace has a large number of lenders allowing you to compare rates, offers, and find a good fit. Seeing your options takes just a few minutes.

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Where Can I Obtain a HEL or HELOC?

Almost all large banks and most community banks offer HELs and HELOCs. Here is a listing of the top 10 providers. As consumer confidence and home values increase, many lenders that put a hold on home equity products during the recession are offering them again.

You don’t have to go to the same bank that issued your first mortgage to obtain a HEL or HELOC. For example, if your mortgage is from Bank of America, you could go to TD Bank for a HEL or HELOC. However, going to the same lender might yield the most favorable rates and terms because the lender has established a relationship with you and knows your history better than other lenders.

If you’re shopping for a home equity line of credit, you can reach out to one lender at a time hoping you find a good deal. Or you can visit an online marketplace, like LendingTree, and review offers from multiple lenders at once. Click here to get started with LendingTree.

Will I Qualify?

Your eligibility for a HEL or a HELOC depends on a variety of factors relating to your financial history. The loan doesn’t depend on your business’ performance or business’ history, so HELs and HELOCs can be easier to get than business loans. This is one reason why they are a popular financing vehicle for startups.

Minimum starting equity

In order to qualify, you typically need to have 20-30 % equity in your home. Equity is your level of ownership in your home. It’s calculated by subtracting your remaining mortgage payments from the market value of the home and dividing the result by the market value of the home. For example, if you have a $400,000 mortgage and still have to pay ¼ of it ($100,000), your equity in the home is $300,000 or 75 % ($300,000 ÷ $400,000). Requiring 20-30 % equity at the outset ensures that you’re not borrowing too much money given your level of ownership in the home.

Credit score

According to Discover, you should have a personal credit score of approximately 620 or higher to qualify for a HEL. Because of the flexibility that they offer, HELOCs typically require even higher credit scores, around 680 or higher. You may be able to qualify with a lower credit score, but higher scores result in better interest rates.

Other debt

The lender will be more comfortable extending you a HEL or HELOC if you don’t have a lot of other debt. Ideally, according to bankrate.com, your debt-to-income ratio should be no higher than 40 to 45 %.

History of mortgage payments and foreclosure

If your home has been foreclosed in the past or you’ve missed mortgage payments in the past, that will hurt your ability to get a HEL or HELOC. If an unexpected event, such as an illness, caused a prior foreclosure, be sure to explain the circumstances to the lender.

Rollover for Business Startups is another way to fund a business that relies on your retirement account. Click here to read our Ultimate Guide to ROBS loans.

How Much Can I Borrow?

Most lenders will allow you to borrow up to 80-90 % of the equity in your home. In the past, lenders would allow you to borrow up to 100 % of your equity, but as credit standards have grown stricter, lenders have reined in that percentage.

Here’s an example of how much you’d be able to borrow:

Maria and Matt own a home that’s valued at $500K, and they’ve paid off half of it (including their down payment). They want to use their home equity to start a new business:

Appraised value of home = $500K
90 % of appraised value of home = $450K
Money Matt and Maria still owe on mortgage = $250K
90 % appraised home value minus amount owed = $200K

Matt and Maria will be able to obtain a maximum of $200K as a HEL or HELOC.

Simply because you can qualify for a large loan doesn’t mean you should take it. The total cost of a HEL depends in part on the size of the loan that you take, so you should calculate how much you need and borrow only that much. That being said, most banks have size minimums for HELs and won’t grant a HEL below $10,000.

In contrast, with a HELOC, you don’t pay interest on unused funds, so it’s often best to get the largest credit line that you qualify for. For example, a $100,000 credit line doesn’t cost more than a $10,000 credit line–the amount of money that you withdraw determines your cost, and having access to a larger credit line gives you greater flexibility in case your borrowing needs change over time. Some HELOCs have a minimum initial draw requirement, meaning that you have to withdraw a certain amount of money (usually $10K) at the outset. The initial draw is sometimes optional, but it helps you qualify for the best rates.

Cost

Interest Rates

HELs and HELOCs are an inexpensive way to finance a business. In June 2015, the national average Annual Percentage Rate (APR) for a $30,000 HELOC was just over 6 % for a HEL and 4.73 % for a HELOC (higher amounts will have lower rates). As the stats show, HELOCs are currently slightly cheaper than a HEL, but the tradeoff is that HELOC interest rates are variable with the market. With most HELs, you are guaranteed the same rate for the entire term of the loan.

HELOCs and HELs are cheaper than most bank business loans and 4-10 times cheaper than alternative business loans! However, interest rates are not the only cost to keep in mind for a HEL or a HELOC. You may be subject to annual fees, prepayment penalties, and other fees.

You can use this home equity search to get estimated interest rates and find lenders near you.

Fees

Here are some other fees that may be tacked on to a HEL or HELOC:

HELs

• Closing costs – Approximately 2-5 % of the loan amount (cover things like application processing, appraisal of home value, etc.).
• Origination fees – Approximately 1 % of the loan amount or less.

HELOCs

• Minimum draw – In some cases, you must withdraw a minimum amount of money after opening a HELOC ($10K-25K). If you don’t need this much money, try to find a HELOC elsewhere that requires a lower minimum or no minimum. You don’t want to pay interest on money you don’t need!
• Annual fees – $25-75, often waived for the first year (applies even if you don’t use the funds in a particular year).
• Application fees – $25-100.
• Appraisal fees – vary based on home location and value.
• Inactivity fees – This is a fee based on non-usage. It’s rare for a bank to charge an inactivity fee, but some credit unions do. It’s normally a small amount (around $100 per year).
• Per transaction fees – Typically a small fee of $5 per draw or less.

This isn’t an exhaustive list. We recommend speaking with the lender about all applicable fees before opening a home equity account.

Prepayment and early closure penalties

Paying back debt early should be a good thing, but unfortunately, you can get hit with prepayment penalties or early closure fees. Some lenders, especially larger banks, charge a penalty if you pay back a HEL or close a HELOC in less than 2-3 years. The penalty for HELs is around 1-3 % of the principal balance, and the penalty for HELOCs is a flat fee of around $300-500. For example, Bank of America charges $450 and Wells Fargo charges $400 if you close a HELOC less than 3 years after opening the line of credit.

A lot of borrowers get hit unexpectedly with these penalties when they sell their homes. Remember, HELs and HELOCs are tied to home ownership, so if you sell your home, you must pay off the loan or line of credit. If you’re not planning to keep your home for at least another 3 years, now may not be the best time to get a HEL or a HELOC.

Repayment

Just like other term loans, a HEL is amortized over several years. This means that you pay back interest and principal every month during the term of the loan, which ranges from approximately 5-15 years.

HELOCs are a bit more complicated. There are two relevant time periods:

• Interest-only draw period (typically 5-10 years) – During this period, you can withdraw funds from your credit line. Minimum monthly payments go toward interest only, though you can pay down principal if you wish by making larger monthly payments.
• Interest plus principal repayment period (typically 10-20 years) – During the repayment period, you can no longer access any funds from your credit line. The HELOC basically transforms into a loan. You must pay back the principal balance of borrowed funds plus interest, so the monthly payments will be higher than they were during the draw period.

Here’s a good visual from CitiBank illustrating the difference:

This two-part repayment structure is one drawback to a HELOC. Mark Mitchell, Head of Small Business Distribution Strategy for TD Bank, normally doesn’t recommend HELOCs to business owners.  “HELOCs, he says, “require the borrower to pay back interest only for the first several years of the term, and some borrowers do so to find out that when the loan matures they can’t afford the payment, putting their personal and business credit in jeopardy.” You can avoid this by planning ahead and setting aside extra cash as your repayment period nears. For example, it probably wouldn’t be wise to splurge on a fancy piece of equipment right before your repayment window begins.

Whenever possible, pay more than the minimum monthly payment during the draw period. This will help prepare you for larger monthly payments during the repayment period. It also helps you build equity in tangible items such as equipment that you finance with the line of credit. As Mitchell explains, if you pay interest alone, “you might not pay down the asset before its usefulness expires, which creates more debt for the business owner. It is like paying interest only on a car loan, then needing to replace the car five years later. Now you need to not only pay off the old vehicle–or roll it over into the new payment–but you’ve got to find financing for the new vehicle as well.”

Can the Lender Freeze My Credit Line?

If you obtain a HELOC, most plans allow the lender to freeze or lower your credit line if the value of your home “declines significantly” or if the lender “reasonably believes” you will be unable to pay back what you borrow due to a “material change” in your financial situation.

If the lender freezes your credit, you can speak to the lender and find out if there is any way to restore the line of credit. For instance, you may be able to prove with documentation that your home value has not “significantly declined” or that a “material change” in your financial situation was just temporary. Alternatively, you can shop around for a new line of credit from a different lender. If another lender extends one to you, you can use the new line of credit to pay off your existing balance.

Investing HEL/HELOC Funds In Your Business – Tax Treatment

When you use home equity to fund a business, you are investing personal funds in your business. This may call for special tax treatment. FitSmallBusiness.com is not a tax expert, and we recommend consulting with a tax professional for all tax matters.

In general, there are two ways that you can treat interest payments on home equity debt on your tax return. You can either deduct interest payments on up to $100,000 of home equity debt as an itemized deduction on your personal tax return. Alternatively, you can deduct the interest payments as a business expense (e.g. on your Schedule C if you’re a sole proprietor or on your business return). For most businesses, this latter option is more beneficial.

Bottom Line

Home equity loans and lines of credit are inexpensive ways to finance your business, a HEL for predictable and one-time costs and a HELOC for more variable or staggered expenses. If you have at least 20-30 % equity in your home and an uncheckered financial history, you should be able to qualify.

For those considering tapping into their property’s equity, take a look at LendingTree. Their online marketplace has a large number of lenders allowing you to compare rates, offers, and find a good fit. Seeing your options takes just a few minutes.

Visit LendingTree