The Pros and Cons of Using Home Equity to Pay Business Debt[yoast-breadcrumb]
The Pros and Cons of Using Home Equity to Pay Business Debt
Starting or running a small business can be an incredibly rewarding endeavor. However, it also comes with many financial challenges. One of the biggest hurdles for many small business owners is accessing enough capital and cash flow to cover expenses and keep the business afloat. This is especially true in the early stages of a business, before it has built up a steady revenue stream.
When business finances get tight, many entrepreneurs start looking for creative ways to access more financing. One option that often gets considered is tapping into home equity – using the value of your home as collateral for a loan or line of credit. This can provide a useful influx of cash, but also carries risks that need careful consideration.
What is Home Equity?
Before weighing the pros and cons of using home equity for business financing, it helps to understand exactly what home equity is. Home equity refers to the portion of your home that you fully own, free of any mortgage debt. For example, if your home is worth $300,000 and you owe $180,000 on your mortgage, your home equity is $120,000.
Homeowners can use home equity in a few different ways to access financing:
- Take out a home equity loan – This provides a lump sum of cash upfront, with a fixed repayment schedule and interest rate.
- Open a home equity line of credit (HELOC) – This functions more like a credit card, allowing you to access funds as needed up to a set limit.
- Do a cash-out mortgage refinance – This lets you refinance your existing mortgage for a higher amount to pull cash out.
With all of these options, your home acts as collateral – meaning the lender can foreclose if you default. So you are putting your property at risk when tapping home equity.
The Potential Benefits
Using home equity to finance business expenses or growth has some potential upsides to consider:
- Access to capital – For many small businesses, one of the biggest roadblocks is simply not having enough capital to cover expenses, invest in growth, or weather an economic downturn. Home equity unlocks funds you likely wouldn’t qualify for otherwise as a new business.
- Potentially lower interest rates – Since home equity loans and lines are secured by your property, they often come with lower interest rates than unsecured financing options like business credit cards or short-term loans.
- Flexible repayment terms – Depending on the type of home equity financing, repayment terms can be quite flexible. For instance, HELOCs allow you to draw and repay funds as needed.
- Interest may be tax deductible – If you use the funds for legitimate business purposes, the interest paid on home equity loans or lines may be tax deductible as a business expense.
For many small or early-stage businesses, these benefits make home equity an attractive option when other financing doors have been closed. The influx of capital and flexible repayment can provide much-needed breathing room.
The Potential Downsides and Risks
However, tapping into home equity also comes with considerable risks and downsides to weigh:
- Putting your home at risk – With any type of home equity financing, you are putting your actual property and residence on the line as collateral. Defaulting could lead to foreclosure.
- Repayment challenges if business struggles – Tying business financing to your home equity can be dangerous if the business underperforms. You still have to make home loan payments even if the business isn’t generating revenue.
- Rising interest rates – HELOCs often start with low teaser rates that adjust over time. Payments can spike if interest rates rise.
- Prepayment penalties – Some home equity loans impose fees if you pay off the balance early. This limits flexibility if business performance improves.
- Debt can exceed home value – It’s possible to borrow more than your home equity through refinancing. This leaves you “underwater” on the property.
- Impacts personal credit – Poor business performance that leads to missed home loan payments will show up on your personal credit report and hurt your score.
Juggling home and business financing simultaneously compounds risk. Before tapping home equity, think critically about whether you can manage repayment if business revenues fall short of projections.
Alternatives to Consider
If the risks of using home equity financing make you uneasy, some alternatives to consider include:
- Bootstrapping and controlling costs to extend your runway with current capital
- Crowdfunding through platforms like Kickstarter or GoFundMe
- Applying for a small business loan through the SBA
- Reaching out to angel investors or venture capital firms for funding
- Business credit cards for smaller, short-term financing needs
- Peer-to-peer lending marketplaces such as LendingClub
- Invoice factoring to access cash faster from outstanding invoices
Some of these options may come with higher costs and interest rates. But they also don’t put your home at risk, so evaluate them closely before using home equity.
Questions to Ask Yourself
Deciding whether to use home equity financing for business purposes is ultimately a personal decision that requires careful thought. Before moving forward, here are some key questions to ask yourself:
- How much equity do I currently have in my home? What is my loan-to-value ratio?
- What type and amount of home equity financing makes sense for my needs?
- What are the specific rates, fees, terms and tax implications?
- What happens if I lose equity during a housing downturn?
- Do I have a solid business plan and projections to repay the financing?
- What alternatives should I consider before putting my home at risk?
- Am I comfortable with the worst-case scenarios, like foreclosure?
- What happens if my business partner(s) default on shared home equity loans?
- How will this impact my personal credit and finances?
Working through questions like these will help you make an informed decision about whether tapping home equity is the right move for your business situation.
The Bottom Line
At the end of the day, the choice comes down to your risk tolerance and comfort level. Using home equity to fund a business or pay off debt is certainly an option, but one with hazards if not approached carefully. Make sure you fully understand the pros, cons and alternatives before moving forward. Seek professional advice from an accountant, lawyer and financial advisor as needed. And proceed with clear eyes about the potential downsides.
With proper planning, home equity can be a valuable financing tool for some business owners. But it’s certainly not the right choice for everyone. Think critically, run the numbers, and explore all your options before putting your property on the line.