Home Equity and Your Business

Perhaps you need to upgrade your equipment or hire new staff. Or maybe you’re looking to move from being a staff technician to launching your own business. Either way, you’re considering a home equity loan to generate needed capital.

“There are advantages and disadvantages of a home equity loan,” says Diane Sandstrom, consulting manager for Duquesne University’s Chrysler Corporation Small Business Development Center in Pittsburgh. “The No. 1 advantage is that 99 percent of the time, you’ll get a lower interest rate.” In addition, the bank’s due diligence and turnaround time for a home equity loan will be generally less than a standard commercial loan.

However, a bank will require you to pledge the equity of your home as collateral on the note and will require assurance that you’ll be able to make payments. If the business fails, you may be placing your home in jeopardy. Here are some factors to consider before moving forward.

Have a Plan
If you haven’t already, create a business plan for your new or expanded business. “A business plan is a fabulous tool to look at all aspects and scenarios of what could happen,” Sandstrom says. “It doesn’t have to be a million pages long, but it should have general company information; a thorough marketing section; a management section; and a financial section, including a cash-flow projection.”

Many traditional commercial lenders minimize the risk of loaning money to new businesses by reviewing business plans to evaluate a business’s ability to repay the debt. Commercial banks will examine your ability to make payments until the business is cash flowing, so in addition to the business plan, craft a home budget, and factor in your existing home mortgage and other fixed expenses.

Your plan should indicate how much financing you’ll need and from what sources. For example, if you need a total of $100,000—of which $25,000 will come from a home equity loan, $25,000 from existing savings and the remainder from other investors—don’t start spending the money from your savings and your home equity loan until you’ve secured the other $50,000.

Shop Around
“It does pay to shop around,” Sandstrom says. Visit as many lenders as possible to find not only the best rate but also the loan terms that work best for your business. Sometimes, the lender who offers the lowest rate may have higher closing costs or balloon payments. Often adjustable rates are lower than fixed rates but can quickly become more expensive as rates rise. If a potential lender is pushing you toward a particular product or is rushing you through the terms, remember that you can always walk away.

The Federal Trade Commission (FTC) says, “If you don’t understand any loan terms and conditions, ask questions.” The FTC’s Web site offers a checklist of terms to ask your lender at www.ftc.gov/bcp/conline/pubs/alerts/shopeqtyalrt.

This same Web site includes information about how to check your credit score. The better your credit score, the better an interest rate you can negotiate with lenders. “Most banks price their loans according to risk,” says Donna Holmes, director of the Penn State Small Business Development Center in University Park, Pa. The lesser the risk, the lesser the interest rate that you’ll receive.

The above checklist also allows you to compare three different loans to determine which one will best suit your business.

Consider a Commercial Loan
Know the exit strategy of your business. If your business will be a single-person enterprise, a home equity loan could be adequate for a small expansion or start-up. However, if you envision growing the business to encompass several employees or accrue value so that it can be sold, consider using a business loan to establish business credit.

Martin Zients, a certified business analyst at Florida Atlantic University's College of Business Small Business Development Center in Boca Raton, Fla., suggests the decision to use a home equity loan or a business loan should be based on personal credit considerations. A business loan will not affect an individual's credit score nor will it be noted on a personal credit report, but it will help establish business credit. A home equity loan or line of credit will appear on a personal credit report and is made to an individual.

Your Alternatives
The Small Business Administration (SBA) has several alternative loan programs, including micro-loans, which are unsecured loans ranging from $5,000 to $50,000 and do not require using your home equity as collateral. The SBA also introduced the Community Express Loan program that offers banks more leeway in lending to borrowers with weaker credit. The loans can max out as high as $250,000. Although both of these loan programs generally carry higher rates, they can be closed rapidly, in as little as eight to 10 days.