September 28, 2022

Unitranche

Supportive Business Potential

Should you use home equity to start a new business?

Can I pull equity out of my house to start a business?

Home equity hit record highs during the Covid pandemic, with the average American homeowner sitting on over $170K of tappable equity at the end of 2021.

At the same time, a record 500,000 Americans became unincorporated self–employed workers.

Of course, it costs a lot of money to start and run a business. Which leaves many wondering, can you tap into that pent–up home equity to fund a new business venture?

The short answer is yes. But you should explore your options carefully and make sure it’s a sound financial move. Here’s what to do.


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How to use home equity to start a business

Given that most banks are notoriously shy about lending to startups, you may have to rely on your own funding. For many, that means tapping into home equity.

Generally, when you withdraw home equity, there are no specific rules about how you can spend the funds. So you’re free to use the cash for any business–related purposes.

There are a few basic steps to get started:

  1. Assess your needs – You need a cash flow forecast showing your anticipated monthly income and outgoings for your new venture’s first three years or longer. Of course, those can only be estimates. But be realistic and when in doubt, estimate high. Thirty–eight percent of startups fail because entrepreneurs have too little funding in place
  2. Work out how much home equity you can tap – Your equity is the amount by which your home’s value exceeds your mortgage balance. But, unless you have a VA loan, you won’t be able to borrow all of that. Most lenders will want you to retain 20% of your home’s value. That means even if you home was fully paid off, you’d only be able to borrow up to 80% of its value
  3. Choose the right loan type – Many homeowners can choose from a cash–out refinance, a home equity loan, or a home equity line of credit (HELOC). This choice will have implications for your short– and long–term costs (more information below)
  4. Find the best deal on your cash-out loan – With interest rates on the rise, it’s more important than ever to shop around for a low rate. Whether you’re using a cash–out refinance, home equity loan, or HELOC, your rate will impact how much equity you can withdraw and what you’ll pay your bank in the long run

Things are a little easier if you wish to buy an existing business. You’ll then have a much better idea of future cash flow. But you’ll want to have a business accountant look over the latest audited accounts and recent day–to–day numbers.

Ways to tap your home equity

There are three main loan types that allow you to tap home equity to start a new business. These include:

  1. Cash-out refinancing – A whole new mortgage to replace your existing one. This will likely have the lowest interest rate and monthly payment, but will also have the highest closing costs and longest loan term. Read more about cash–out refinances here
  2. Home equity loan – A second mortgage that runs in parallel with your main (“first”) mortgage. You’ll have two mortgage payments each month (provided your home is currently mortgaged) but for a shorter period. And your closing costs are likely to be lower than for cash–out refinancing. Read more about home equity loans here
  3. Home equity line of credit (HELOC) – These are especially good for consultants and freelancers. Because they let you even out your earnings, borrowing when you need to, repaying when times are good and then borrowing again up to your credit limit. And you pay interest only on your balance. Very cheap (or free) to set up. But they have drawbacks. So read more about HELOCs here

Research your options carefully and talk to a loan officer about the pros and cons of each one. It’s likely one of the three loan types will be better suited to your situation than the others.

Timing your cash–out loan correctly

This is a key point: If you want to use home equity to fund a new business, you likely need to apply for the loan before you quit your current job and set out on a new venture.

You’re more likely to get your application approved if you apply while you’re still an employee. Because you can show a consistent income and a solid record of employment.

If you wait until after you’ve resigned from your current post, you won’t be able to prove that you can comfortably afford your monthly payments. And few – if any – mainstream lenders will touch you.

As a rule of thumb, self–employed borrowers usually need a two–year history of self–employment income to get approved for a loan. (Though in some circumstances one year is enough.) If you quit your job and then try to apply for home equity financing right away, there’s a good chance you’ll be out of luck.

Pros and cons of using a mortgage to fund a new business

There are some real benefits to using home equity for a business startup – as well as some serious pitfalls. Here’s what you should consider before taking the leap.

You have the potential to borrow large sums

The main advantage of using home equity to start a new business is that it often gives you a large sum.

How much you can get will depend on how long you’ve owned your home and the property market where it’s located. But many find that a cash–out refinance or a second mortgage provides more cash than any other form of borrowing open to them.

Home equity interest rates are low

The other big advantage of home equity financing is that interest rates are low compared to other types of borrowing.

At the time this was written in Feb. 2022, mortgage rates were rising to the high–3% and low–4% range. Though much higher than the record lows seen in 2020 and 2021, those rates are still incredibly low compared to options like a personal loan or small business loan.

You’re putting your home on the line

The biggest risk of home equity financing is that any sort of mortgage requires you to put your home on the line. And, if you fall too far behind with your payments, you could face foreclosure.

So it’s worth exploring other, unsecured, borrowing options and seeing how they compare to a mortgage.

  • Might a personal loan provide you with the money you need? (And can you get a low rate on one?)
  • Do you have a wealthy friend or family member who might back you?
  • Can you find a business partner with the capital to fund your startup?
  • Is it worth approaching your bank or credit union?

You might still be in trouble if your venture goes bad. But at least those unsecured lenders can’t directly go after your home, even if their interest rates are higher.

Small businesses have a high failure rate

None of this would matter if you were guaranteed success. And, presumably, all entrepreneurs believe their startups stand a good chance of thriving. But there are some real challenges to be aware of.

According to the US Small Business Administration, “About two–thirds of businesses with employees survive at least 2 years and about half survive at least 5 years.” That statement was from 2012. But 2021 data from the Bureau of Labor Statistics suggest things haven’t changed much since then.

Of course, that doesn’t mean your venture will fail. And many small businesses are a genuinely good investment.

These stats are only meant to underscore the riskiness of tying your home to a new business. You want to be absolutely sure that, even in a worst–case scenario, you’ll be able to make your mortgage payments and your house won’t be in jeopardy.

Make sure you have a solid business plan

If you try for a personal loan or small business loan, the first thing a bank will ask for is your business plan. And one of those is essential, even if you’re not borrowing at all.

The discipline of writing a business plan will cause you to question your own assumptions. And it will force you to see your new venture in a more rounded way. You’ll also have to make financial projections, which might give you some surprising insights.

The U.S. Small Business Administration provides guidance about business plans. And there are sample plans at that link, too.

So write yours. And then show it to friends who are entrepreneurs or business professionals. Get them to pick it apart. You want to identify potential problems as early as possible so you can address them.

Going through that process can give you real confidence in the soundness of your venture. And that, in turn, can make it much less stressful and scary when you tap your home equity to start a new business.

Your next steps

With home values near record highs, it’s a fruitful time for homeowners to tap their equity.

Using those funds to start or improve a business venture could be the right move, as long as you consider all your options carefully and have your financial plan clearly outlined.

If you’re ready to take the next steps, connect with a mortgage lender who can check your eligibility and give you a quote for home much equity you’re eligible to borrow. You can get started right here.

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.