The United States is home to many of the most successful entrepreneurs in the world, producing a steady stream of new businesses and entrepreneurs every month. According to the United States Census Bureau, for example, the applications for new businesses totaled over 420,000 in April 2022 alone.
But as many entrepreneurs will tell you, the road to self-employment can be very challenging. One of the many challenges that new entrepreneurs face is the question of how to raise money to finance their business. Traditional options include small business loans, personal savings, or loans from friends and family. But with home prices rising substantially in recent years, many entrepreneurs may be tempted to look at home equity as a source of business financing.
- It is possible to use home equity as a source of funding for a new business.
- This can be done through cash-out refinancing, home equity loans, or home equity lines of credit (HELOCs).
- There are pros and cons to using home equity for business purposes.
Using Home Equity for Business Financing
The average price of a home in the United States rose by almost 80% between Q1 2012 and Q1 2022. Since home equity is equal to the difference between the current market price of a home and its outstanding mortgage debts, many Americans have seen their home equity rise along with this increase in home prices. For homeowners in this favorable position, there are several ways that you can use your home equity as a source of cash.
The simplest way to raise cash from your home equity is, of course, by selling your home. If you take this approach, then your proceeds from the sale would be roughly equal to your home equity, minus any applicable taxes and closing costs. On the other hand, there are also ways to extract cash from home equity while retaining ownership of your home. For example, you could undertake a cash-out refinance, or acquire a home equity loan or Home Equity Line of Credit (HELOC).
As its name suggests, a cash-out refinance is a type of mortgage refinance transaction in which you receive a lump sum of cash. It typically works by replacing your mortgage with a new mortgage, at a time when your home equity has increased since the time of your first mortgage. Homeowners in this scenario can then pay off their original mortgage with the new mortgage, pocketing the difference.
To illustrate, consider a scenario where you purchased a home for $200,000 and secured a mortgage for 80% of the price of the home, or $160,000. Some years later, the home appreciates in value to $300,000. In this scenario, the bank might allow you to refinance using a new mortgage worth 80% of the current market price, or $240,000. In that scenario, you would pay off the previous mortgage and be left with $80,000 in cash. In practice, your actual cash proceeds would be less than this, since you would need to cover closing costs. Moreover, your income and creditworthiness would still need to qualify for the new mortgage.
Home Equity Loans and HELOCs
If refinancing is not an available or attractive option for you, another approach would be to take out a traditional home equity loan. Like a cash-out refinance, home equity loans offer a lump sum of cash, and typically come with relatively inexpensive fixed interest rates and fixed amortization schedules. They are secured by your home, so it is very important to never miss any payments.
Another option would be to obtain a Home Equity Line of Credit (HELOC). These loans operate as revolving lines of credit, allowing you to withdraw funds on a schedule of your choosing rather than receiving all of the loan proceeds at once. HELOCs also allow you to pay only the interest on the loan, allowing you to minimize your monthly payments. Whereas traditional home equity loans carry fixed interest rates, HELOCs come with variable rates, which means you are more exposed to interest rate risk. Although HELOCs initially allow a high level of flexibility, they automatically begin requiring scheduled principal repayments after the end of an initial period—often set between five and ten years—known as the draw period.
Pros and Cons
As with most things in finance, there are pros and cons to each of these approaches. The main benefit to using home equity to start a business is that it can be a lot more accessible while also offering lower interest costs. Applying for a traditional small business loan can often be a challenging process, with many lenders reluctant to extend capital to a still-unproven venture. It is a common adage among entrepreneurs that “banks only wish to sell you an umbrella when it is not raining.” In other words, they are happy to lend your business money, but only when it is already successful and does not need the funds.
Although relying on home equity loans can help get around this problem, it’s not without its risks. After all, there is a good reason why banks are reluctant to lend money to new businesses. With roughly 20% of new businesses failing in their first year, and 65% failing in their first decade, there’s no denying that there is real credit risk involved. And since relying on home equity means putting your own home at risk, entrepreneurs should carefully consider whether that is a risk they are willing to take. To put it plainly, using home equity to start your business means that, if your business fails, you could potentially lose your home as well.
Can you use home equity as collateral?
Yes, you can use home equity as collateral. When you are taking out a home equity loan or a HELOC, for example, your house is pledged as collateral for the loan. That means that, if you fail to keep up your payments, the lender could foreclose on you and take ownership of your home.
Can I start a business with no money or collateral?
Yes, it is possible to start a business with no money or collateral, although of course whether this is possible or prudent will depend on your specific risk tolerance and circumstances. For example, an entrepreneur could start a business by selling equity to outside investors, receiving government grants, or relying on money from friends and family. Cash-strapped entrepreneurs will also often refrain from paying themselves a salary until their business becomes financially self-sustaining.
What kind of home equity loan allows you to receive a lump sum?
A cash-out refinance, or a traditional home equity loan, both offer a lump sum of cash at the time the loan is taken. A HELOC could also be used in this manner, in that you could choose to immediately withdraw the full balance of the loan. Bear in mind that, in the case of HELOCs especially, this could expose you to significant interest rate risk.
The Bottom Line
If in spite of these risks you feel that using home equity is still your best option, there are some additional steps that new entrepreneurs can take to help manage their risk. First, it is worth consider that—generally speaking—not all business ventures will be equally risky. By surveying the industries and entrepreneurs in your region, you may determine that certain types of businesses have better chances of survival than others. Moreover, within any given business, some uses of capital might be more risky than others. For instance, inventory that is subject to redundancy risk or spoilage may carry more risk, as compared to inventory that will retain its value indefinitely with limited risk of damage or depreciation.
Regardless of how you choose to finance your new business, doing extensive due diligence on your industry and competitors, and preparing a detailed budget that will allow you to plan and preserve your cash, is generally well worth the time required. Seeking the input of trusted advisers, such as experienced entrepreneurs in your region or chosen industry, may also help you maximize your chances of success.
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