Tapping into your home's equity can be a great way to boost your business. Getting traditional financing may be difficult, so if you have substantial equity built already it may not be a bad idea. There are many things to consider before you pull the trigger, interest rates and payments obviously being one of them.
There are pros and cons for taking out a loan against your home, and this is all going to depend on your business needs. For example, if you need a short term loan to fill orders and your clients can't pay you for 30-60 days out, it's reasonable to say that it's a solid strategy. However, if you're taking out a loan to start a new venture that carries a lot of risks, you're putting your business and home on the line.
Home Equity Loan or Line of Credit
First of all, it's important to distinguish the difference between the two.
A home equity loan is a lump sum loan that you get all at once. The lender will write a check to you based on your home's value while maintaining that your loan-to-value ratio is kept at a reasonable rate. You'll end up paying a fixed rate for a fixed number of years that's amortized. The payment structure is identical to what you're paying for your mortgage.
A LOC (line of credit) works like a credit card. You'll establish a credit limit that the lender agrees to and you can borrow against it anytime you want. Interest will only be charged when you draw against the LOC.
For Businesses With Expected Incoming Revenue
If you're in the business with vendors who pay out 30-60 days after invoicing (also known as invoice financing), you might be in a situation where you're looking to scale your business but simply don't have the funds. In situations like this, a HELOC (home equity line of credit) would be the best option. Since you know you have revenue coming in, you can easily repay the HELOC after the vendors pay you.
Taking a home equity loan may be on the riskier side and it'll all depend on the reason you're taking out the loan. If you're looking to expand rapidly that involves large one-time purchases, a home equity loan may be the right fit. Think about it this way: HELOCs are great for cash reserves to cover expenses while waiting for vendors to pay, and home equity loans are great for businesses looking for large purchases for expansion.
When NOT to take out a Home Equity Loan
Taking out a home equity loan does come with a price. If you're looking to start a business, you'll probably want to stay away from taking out a loan. There's obviously quite a bit of risk while doing a start-up and the last thing you want to do is put your home at risk. If the business isn't successful, you'll be putting both home on the line. If you can't pay the home equity loan, the lender can foreclose on you.
Businesses such as retail or restaurants will generally carry the highest amount of risk. These both depend on whether or not you can sell a product that customers like. On the other hand, taking out a loan for a service type of business may be less risky.
If You're Thinking of Applying, Boost Your Credit First
Credit is everything to lenders. No matter what lenders say about 'we look at different factors", a lot of weight still goes on your credit score. You'll be surprised at how big of a difference a few points can make when it comes to determining your interest rates.
Banks typically have various tiers that determine your rate- so even one single point can cost/save you hundreds of dollars in interest. So what's actually a good credit score to have?
According to AAAcreditguide,
Mortgage lenders, on the other hand, typically require that your average FICO credit score pulled from all three credit bureaus is no less than a 640- and with a 640 credit score, you'll be looking at higher interest rates that add hundreds of dollars to your mortgage payments.
Checking your credit score is easy: sites like Credit Karma and Credit Sesame offer free credit scores every week & month. Although this may not be the exact scores that your banks will use, it's a good indication of where you stand. If you find out that your score isn't as good as you thought, you can take steps to improve your credit score.
Be Smart and Budget Carefully
Taking out a home equity loan isn't frowned upon. In fact, it's a great way to leverage your home's equity to get better interest rates. Always make sure you can comfortably afford the payments and remember that you're taking out a loan against your home!