Can I withdraw equity from my home to start a business?
Home equity has reached record highs during the Covid pandemic, with the average US homeowner having more than $170,000 of exploitable net worth at the end of 2021.
At the same time, a record 500,000 Americans became unincorporated self-employed.
Of course, it costs a lot of money to start and run a business. Which leaves many people wondering, can you tap into your pent-up home equity to fund a new business venture?
The short answer is yes. But you need to explore your options carefully and make sure it’s a good financial decision. Here’s what to do.
Check your home equity financing options. Start here (February 23, 2022)
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How to Use Home Equity to Start a Business
Since most banks are notoriously reluctant to lend to startups, you may have to rely on your own funding. For many, this means tapping into the equity in their property.
Generally, when you withdraw equity from your home, there are no specific rules on how you can spend the funds. You are therefore free to use the money for commercial purposes.
There are a few basic steps to get started:
- Assess your needs – You need a cash flow forecast showing your expected monthly income and expenses for the first three or more years of your new business. Of course, these 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
- Determine how much equity in your home you can leverage – Your equity is the amount by which the value of your home 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 keep 20% of the value of your home. This means that even if your home was fully paid off, you could only borrow up to 80% of its value.
- Choose the right type of loan – Many homeowners can choose between a cash refinance, a home equity loan or a home equity line of credit (HELOC). This choice will have implications on your short and long term costs (more on this below)
- Find the best offer for 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 use a cash refinance, home equity loan, or HELOC, your rate will affect how much equity you can withdraw and what you’ll pay your bank in the long run.
Things are a bit easier if you want to buy an existing business. You will then have a much better idea of future cash flows. But you’ll want a business accountant to review the latest audited accounts and recent day-to-day figures.
Check your eligibility for withdrawal. Start here (February 23, 2022)
Ways to leverage the equity in your home
There are three main types of loans that allow you to leverage the equity in your home to start a new business. These include:
- Refinancing by collection – A brand new mortgage to replace your existing mortgage. This will likely have the lowest interest rate and monthly payment, but will also have the highest closing costs and longest loan term. Learn more about cash-out refinances here
- Home Equity Loan – A second mortgage parallel to your main mortgage (“first”). You will have two mortgage payments per month (provided your home is currently mortgaged), but for a shorter period. And your closing costs will likely be lower than a cash refinance. Learn more about home equity loans here
- Home Equity Line of Credit (HELOC) – These are particularly interesting for consultants and freelancers. Because they allow you to balance your income, borrow when you need it, repay when things are going well, then borrow again up to your credit limit. And you only pay interest on your balance. Very cheap (or free) to set up. But they have drawbacks. So learn more about HELOCs here
Research your options carefully and talk to a loan officer about the pros and cons of each. It is likely that one of the three loan types will suit your situation better than the others.
Schedule your cash loan correctly
This is a key point: if you want to use the equity in your home to finance a new business, you will likely need to apply for the loan. before you left your current job and started a new business.
You have a better chance of getting your application approved if you apply while still employed. Because you can show consistent income and a strong employment record.
If you wait until you resign from your current job, you won’t be able to prove that you can comfortably pay your monthly payments. And few – if any – of the traditional lenders will touch you.
As a general rule, self-employed borrowers usually need a two-year history of self-employment income to get approved for a loan. (Although in some circumstances, a year is enough.) If you quit your job and then try to apply for home equity financing right away, chances are you’re out of luck.
Check your eligibility for withdrawal. Start here (February 23, 2022)
Advantages and Disadvantages of Using a Mortgage to Fund a New Business
There are real benefits to using home equity for a business start-up – as well as some serious pitfalls. Here’s what you should consider before taking the plunge.
You have the possibility to borrow large sums
The main benefit of using home equity to start a new business is that it often earns you a significant amount of money.
How much you can get will depend on how long you’ve owned your home and the real estate market it’s in. But many find that a cash refinance or second mortgage provides more money than any other form of borrowing available to them.
Interest rates on home equity are low
The other big advantage of home equity financing is that the interest rates are low compared to other types of borrowing.
As of this writing in February 2022, mortgage rates were climbing in the high 3% and low 4% range. Although much higher than the record lows seen in 2020 and 2021, these rates are still incredibly low compared to options like a personal loan or a small business loan.
You put your house in danger
The biggest risk with home equity financing is that any type of mortgage requires you to put your home on the line. And, if you fall too far behind on your payments, you could face foreclosure.
So it’s worth exploring other unsecured borrowing options and seeing how they compare to a mortgage.
- Can a personal loan bring you the money you need? (And can you get a low rate on one?)
- Do you have a wealthy friend or family member who could support you?
- Can you find a business partner with the capital to fund your startup?
- Is it worth approaching your bank or credit union?
You could still be in trouble if your business goes wrong. But at least these unsecured lenders can’t go after your home directly, even if their interest rates are higher.
Small businesses have a high failure rate
None of this would matter if success was guaranteed to you. And, presumably, all entrepreneurs think their startups have a good chance of thriving. But there are real challenges ahead.
According to the United States Small Business Administration, “About two-thirds of businesses with employees survive at least 2 years and about half survive less than 5 years. » That statement was from 2012. But 2021 data from the Bureau of Labor Statistics suggests that not much has changed since then.
Of course, that doesn’t mean your business will fail. And many small businesses are a real good investment.
These statistics are only meant to highlight the risk of tying your home to a new business. You want to be absolutely certain that, even in the worst-case scenario, you’ll be able to make your mortgage payments and your home won’t be in jeopardy.
Make sure you have a solid business plan
If you’re trying to get a personal loan or a small business loan, the first thing a bank will ask you is your business plan. And one of them is essential, even if you don’t borrow 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 business in a more comprehensive way. You will also need to make financial projections, which could give you some surprising information.
The US Small Business Administration provides guidance on business plans. And there are also sample plans on this link.
So write yours. And then show it to business or professional friends. Ask them to take it down. You want to identify potential problems as early as possible so that you can fix them.
Going through this process can give you real confidence in the strength of your business. And that, in turn, can make it much less stressful and scary when you’re tapping into your home equity to start a new business.
Your next steps
With real estate values nearing record highs, it’s a fruitful time for homeowners to dip into their net worth.
Using these funds to start or improve a business venture could be the right decision, provided you carefully consider all your options and have a clear financial plan.
If you’re ready to take the next steps, contact a mortgage lender who can verify your eligibility and give you a quote for the equity in your home you’re eligible to borrow. You can start here.
Show me today’s rates (February 23, 2022)
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