A Home Equity Line of Credit (HELOC) can be a cheap source of credit to meet the short-term demands of your business.
Home Equity Line of Credit, is a secondary mortgage loan where you can lend for business purposes.
The home equity loan rates are relatively cheaper than traditional sources of credit.
A Home Equity Line of Credit (HELOC) can be a cheap source of credit to meet the short-term demands of your business. Since it is a line of credit, you can manage this loan more flexibly than a long-term home equity loan used for business or higher-interest business loans. However, you also may want to explore the risks of a secondary mortgage and consider all other business credit sources before taking a HELOC.
What is a HELOC?
HELOC, abbreviated for Home Equity Line of Credit, is a secondary mortgage loan where you can lend for business purposes through the equity trapped in your home. It is similar to any line of credit, and you can use only a certain portion of your credit limit. You only pay monthly interest on the amount you owe each month.
There are different use cases of home equity vs. HELOC, and both secondary mortgages have distinct advantages and disadvantages. A home equity line of credit is different from a home equity loan, allowing business owners to take a lump sum amount upfront and pay it back in installments. Let's explore.
How to Use a HELOC to Start a Business
Many lenders require you to operate for at least 6-24 months before providing a business loan. Borrowers consider a secured home equity loan to start a business because it offers lower interest rates, higher credit limits, and lower margins than unsecured business loans. If you want to buy capital goods, it's best to take a home equity loan and repay it monthly. A home equity line of credit to start a business can help secure your working capital needs like raw materials, electricity, labor, rent, etc.
Step 1. Check Eligibility
The first step is to check your eligibility with lenders. The loan-to-value (LTV) ratio, the percentage of home equity you can borrow, decides the final quantum of loan limit.
Some lenders offer a fixed LTV on their products, while others are open for negotiation. You can get up to 80% of your home equity as credit if you have a good credit score and low debt compared to your income. You may need to provide the following details to the lender to check your eligibility -
- Home Valuation
- Property Type
- Outstanding Mortgage Balance (if any)
- Credit Score
- Line of Credit Requirement
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Step 2. Find a lender and apply
Now it's time to research. It's a good sign that you are reading this article because it can help you find the right lender or maybe seek an alternate source of credit altogether. Here are some things to consider when finding a lender-
APR is a good metric that measures the interest rate and the closing fees required to procure the HELOC. However, since home equity line of credit loans primarily have adjustable rates, the APR may not accurately calculate all future payments.
0Repayment Terms: HELOCs have different types of repayment options. You can get an interest-only draw period, during which time you may only pay the interest. Ask for a full repayment schedule of your loan from the lender.
After applying, your lender is bound by law to provide you with a loan estimate document containing all the loan's important terms and conditions within three days.
Step 3. Invest funds in business
Once your application is processed, your lender will call you to a loan processing center for documentation. You may need to sign several affidavits and declarations, including a promissory note. You will be given a Closing Disclosure, the HUD-1 Settlement Statement or Truth in the Lending disclosure form.
The Closing Disclosure will mention all repayments terms and conditions. A closing fee is charged upfront from your line of credit limit. You can invest the funds in business once your lender completes the disbursal process.
Step 4. Start repaying
The repayment term consists of two phases: the draw and repayment periods. You may skip the principal payment during the draw period but still serve the accrued interest. You cannot withdraw any more from your loan limit at the end of the draw period.
Your outstanding balance is amortized, and your loan payments will significantly increase to factor in the principal repayment. You can repay the loan as a lump sum balloon payment or spread over the repayment period.
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Pros and Cons of using a HELOC for business
- Great for Cash flow - HELOC for business expense is a revolving credit designed to increase your working capital and manage cash flow shortages. You can use this line of credit to purchase raw materials that can be repaid in the short term.
- Low APR- The average industry rate for HELOC is currently around 4%, generally lower than home equity loans, business loans, personal loans, or credit cards. If you have low debt-to-income, good creditworthiness, strong cash flow, and sufficient equity in your home, you may get better deals on a home equity line of credit.
- Pay Only Interest - Some lenders offer an interest-only home equity line of credit, where you pay only the accrued interest during the draw period. You can also repay the entire principal without any pre-closure charges. This may help new business owners stabilize their cash flow.
- Multiple Use Cases - You can use money from a HELOC to finance home improvements, repair rental properties, and even cover medical expenses. However, make sure to repay them ASAP.
- Draw Period - A home equity line of credit is often confused with a permanent line of credit. However, the former gets amortized after the end of your draw period, after which you can't withdraw from your available limit. You need to repay the total debt (principal+interest) in installments. This can suddenly increase your loan payments, so be prepared beforehand.
- Risk of Foreclosure - A HELOC loan is a secondary mortgage with foreclosure risks if you can't repay the loan. Your lender may also charge you higher penalties in HELOC than other types of credit like a Small Business Administration loan.
- Variable Interest Rate - Most HELOCs have adjustable interest rates, which may increase or decrease over time. If your loan is indexed to the fed rate, you may have to pay more interest during inflation and rate hikes.
Can you use home equity to buy a business?
Lenders consider HELOCs less risky and don't care how you use the funds. You may use the funds to purchase a business, but check the current liabilities, annual turnover, future cash flows, liquidity options, and economic outlook of the business secured by your home's equity. Buying an existing business has challenges, as does starting your own business from scratch. So, instead of asking I can use my home equity to buy a business, you may ask if I should use my home equity to buy a business.
Alternative ways to fund your business
There are many alternatives to HELOC if you need emergency cash. You may consider 401(k) loans, life insurance policy loans, business loans, personal loans, SBA loans, cash-out refinance, car-title loans, or no-interest credit cards. Each type has pros and cons, so check out the details before taking borrowing funds.
If you require funds up to $100,000, you may consider taking a personal loan rather than a home equity loan. You do not need to provide any collateral, but the loan amount may be capped on the upper side depending on your income, outstanding debt, and creditworthiness. Lenders may quote a higher interest rate on secured vs unsecured loans, but you can negotiate if you have a high credit score or a good cosigner. The loan process is also faster, and you can save money on mortgage fees, advocate fees, and appraisal fees.
A business loan can be harder, but you can save your home from sudden economic shocks. In 2008-09, many Americans defaulted on their home equity line of credit loans after house prices collapsed and mortgage interest rates hiked. If you have a strong business with sound financials, you can get a business loan with favorable terms without collateral. Small business owners may also receive business grants from the government.
If you have a small business, you may benefit in the long run by seeking a line of credit from the Small Business Administration (SBA). SBA loans are a great starting point for small businesses since you can eventually get credit up to $5 million with well-defined, long-term repayment options.
The federal government guarantees small business loans and includes temporary relief programs like the Economic Injury Disaster Loan, which offers a 3.75% rate for 30 years. Most SBA loans are collateral-free, but you can include collateral to get better borrowing limits.
Business Line of Credit
If you require working capital for your business, you can take a business line of credit (LOC) from traditional banks or fintech lenders. It can be unsecured or even guaranteed by the government in case of a small business line of credit. Usually, banks provide 20% of your business's annual turnover as the borrowing limit for a LOC. However, the loan process is slow, and you may require extensive documentation.
Home Equity Loan for Businesses
Using home equity to start a business can do wonders if you are confident of repaying the debt in time. The home equity loan rates are relatively cheaper than traditional sources of credit.
You can also get a HELOC relatively faster than other business loans, and there are no restrictions on using funds. However, it can also be a pandora's box as business risks are unforeseeable. You may want to exhaust all other credit options before leveraging your home equity.
Can a Heloc be used for business purposes?
Yes, a Home Equity Line of Credit (HELOC) can be used for business purposes. A HELOC provides a flexible credit line based on the equity in your home, which can be a cost-effective way to finance business needs. This type of credit can be particularly useful for covering short-term business expenses, investing in growth opportunities, or managing cash flow.
Can I use a HELOC for a down payment?
Yes, you can use a Home Equity Line of Credit (HELOC) for a down payment on a property, including a second home or investment property. A HELOC allows homeowners to borrow against the equity in their current home.
How do you calculate line of equity?
To calculate the equity line (often referred to as a Home Equity Line of Credit, or HELOC), you need to determine how much equity you have in your home. Equity is the difference between the current market value of your home and the amount you owe on any mortgages or loans secured by your home.