Home Equity Loan & Line of Credit Overview
Did you know that almost a quarter of small business owners use a home equity loan (HEL) or home equity line of credit (HELOC) to finance their businesses?
While these are inexpensive ways to finance a business, the main disadvantage is the risk involved. HELs and HELOCs are secured by your home, so if your business doesn’t succeed and you can’t pay back what you borrowed plus the interest, you could lose your home.
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How a Home Equity Loan or Line of Credit Works
Home Equity Loan (HEL):
A home equity loan (often called a “second mortgage”) is a loan secured by your home. You get a lump sum of capital that you gradually pay back with interest over a fixed period of time (typically 5-30 years). A home equity loan typically has fixed interest rates (4-8 %), so your monthly payments are the same throughout the term of the loan.
A home equity loan can be a great way to purchase fixed assets for your business or to invest long term in your business. For example, you might choose a HEL if you’re looking to buy equipment or remodel a storefront. Similarly, HELs are commonly used for funding a startup business or buying an existing business.
Home Equity Line of Credit (HELOC):
A home equity line of credit gives you access to a certain sum of money that can be used on an as-needed basis. The advantage is that you only pay interest on money that you actually use, and as you pay back what you borrow, you get access to that money again.
For instance, if you have a $100,000 line of credit and use $40,000 to buy inventory, you only have to pay interest on the $40,000. As you pay down the $40,000, credit becomes available to you again (like a credit card).
Like a HEL, a HELOC is also secured by your home, but there are key differences. A home equity loan typically has fixed interest rates and a fixed term, whereas a HELOC has variable interest rates and a two-part repayment structure. During the initial 5-10 years, the draw period, you can withdraw funds from your line of credit, and the minimum monthly payments go toward interest only. During the next 10-20 years, the repayment period, the HELOC basically turns into a loan that you have to pay back. You have higher monthly payments going toward principal and interest.
When would you use a HELOC instead of a loan? With a loan, you get a chunk of money and immediately start paying the loan back, regardless of when you use the money for your business. In contrast, a line of credit lets you borrow the amount you need when you need it, and you only have to pay interest on the money you use. As a result, HELOCs are most suitable for variable or unexpected expenses. For example, if you occasionally need money to purchase inventory, or a business emergency arises (e.g. a broken appliance), a home equity line of credit may be a good way to go.
Will I Qualify for a Home Equity Loan or Line of Credit?
Other than being a homeowner, here’s what you need to qualify for a home equity loan or line of credit:
20-30 % equity in your home. Equity is the amount of ownership you have in your home. For instance, if you own a $400,000 home and have paid off $100,000 of the mortgage, your home equity is $100,000 ÷ 400,000 = 25 %.
History of timely mortgage payments and no prior foreclosures.
Not a lot of other debt, with a debt-to-income ratio in the low 40s or less.
You may be able to qualify without meeting every single one of these criteria. For example, if you have a lower credit score, you might still be able to qualify but will have to pay a higher interest rate. Similarly, if you have a stellar credit score, you may be able to qualify with lower equity.
Cost of a Home Equity Loan or Line of Credit
Home equity loans and lines of credit are much cheaper than other business financing options. The reason they are less expensive is because they are backed by your home, making them less risky than other types of loans.
Average interest rates are 4-8 % for a home equity loan and 2.5-8 % for a home equity line of credit. Although HELOCs are currently slightly cheaper than HELs, HELOCs have variable interest rates. If the market heats up, the interest rates could increase. HELs typically have fixed rates.
In addition to interest rates, HELs and HELOCs also have certain fees associated with them. These vary by lender, by commonly assessed fees include origination fees (1 % of loan amount) closing costs (2-5 % of the loan amount) for home equity loans and annual fees, transaction fees, and inactivity fees for home equity lines of credit.
In addition to these fees, most home equity loans and lines of credit have a prepayment penalty if you pay off the loan or close the line of credit in less than 3 years. Therefore, it’s best to use home equity as a business financing tool only if you’re certain of remaining in your home for the foreseeable future.
Maximum Loan Amount
80-90 % of your home equity
5-15 years for a HEL; 5-10 year draw period for a HELOC followed by 10-20 year repayment term.
2.5-8 % APR
Your home serves as collateral.
Have a question?
One of the least expensive methods of funding a business.
May be used to fund a startup, which can help entrepreneurs that have been rejected for business loans.
Interest payments on a HEL or a HELOC may be tax deductible.
No restrictions on how you can use the funds.
Failure to make timely payments can result in the loss of your home.
May carry fees and prepayment penalties.
Tied to home ownership - you must pay off the balance in full when you sell your home.
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