Turning a small business from a dream to a reality is a lot like turning a house into a home. Both require drive, passion, and plenty of equity—both of the financial and sweat variety. And more often than not, it’s tough to get the cash you need to embark on either of these journeys. Applying and securing small business loans can be tricky, and poor credit can complicate matters further by narrowing your options. That’s why you might be considering a home equity business loan instead.
Home equity loans allow entrepreneurs to borrow money against the value of their homes. And in the case of home equity business loans, borrowers can take this money and use it to finance just about any project related to their company. These loans offer access to quick cash without going through the process of securing another kind of small business loan.
But as tempting as a home equity business loan might appear, there are plenty of caveats—and alternatives—that shouldn’t be ignored. There are (potentially significant) drawbacks to home equity business loans, especially if you use them to finance the wrong kinds of investments in your company. We’ll take a look at everything you need to know before you go forward.
There are plenty of reasons why you might consider a home equity business loan to help finance your business.
If you’re seeking small business financing, in reality, you’re probably seeking fast small business financing. But some of the best small business loans on the market require patience. SBA loan applications can take a lot of time to put together because they’re document-intensive in nature, and other bank loans for small businesses can take substantial time before approval (especially if your credit isn’t spotless).
Home equity business loans, however, require much less paperwork and vetting. They can offer entrepreneurs a fast and painless way to access the capital they need to get their plans off the ground.
There are no limitations on how you can use the money from home equity business loans. Most conventional business loans set a framework for how borrowers can use their loaned funds, such as purchasing inventory or buying equipment. Home equity business loans, on the other hand, don’t have such requirements. You’re free to use the money in any way you wish.
The freedom that comes with a home equity business loan could allow you to use the loan for more than one purpose at a time, too. You could divvy up the money to pay invoices and replenish inventory, for example. The money’s yours to use at your discretion, so you can apportion it out in whatever way makes the most sense for your needs.
Home equity business loans typically come with much lower interest rates than other types of small business loans, which can be a pretty enticing offer for small business owners who are already operating on slim profit margins and might not be able (or willing) to pay for high-interest loans. Home loans usually come with an interest rate around 6%, compared to the 7% to 30% you might expect from a business loan.
The lower interest rates on a home equity business loan comes at a price, though. Since your home acts as the loan’s collateral, you risk losing your house if you can’t pay up. If you’re confident that you could pay back the loan, though, this threat isn’t as scary as it may sound.
Yes, home equity business loans have do have upsides—and pretty significant downsides, too. Before applying for a home equity loan ASAP, you’ll need to decide which side pulls more weight.
Obviously, putting your home on the line for your business is a huge risk. On balance, what you stand to gain from a home equity business loan—like flexible lending terms and lower interest rates—probably won’t outweigh what you stand to lose.
Home equity loans are basically like mortgages that you take out on property you already own. If you can’t repay your home equity loan, you lose your property. And if you’re not able to pay your loan, your business isn’t likely to stay afloat much longer, either. Pair these two together, and you’re looking at a dire prospect.
Home equity business loans only really work for businesses that can turn a steady, reliable profit every month. Riskier ventures—such as restaurants, bars, or retail shops—have a higher risk of failure than other kinds of businesses. Plus, many of the above have inconsistent profits every month, which could impact your ability to pay off the loan.
Home equity business loans aren’t a fit for purchasing inventory, either. Although this may seem like a safer use of your equity loan, the value of your inventory could fall, making your investment less valuable over time.
Home equity loans for businesses are subject to the same kind of fees you’d see with a standard mortgage loan—think appraisal fees, application fees, and loan processing fees. You’ll have to pay for a title search and lawyer fees, too.
Since you’ve already bought a house, you know what it’s like to go through these processes. If you take out a home equity business loan, you can expect to do all of this work for a second time (on the same house, no less!). Make sure you keep your checkbook ready, since you’ll be cutting more than a few checks before your home equity loan gets paid out.
There are pros and (plenty of) cons to home equity business loans. In some cases, it’s just downright impractical to get one, particularly if you need to use your loan to purchase real estate or pay rent.
Thankfully, there are tons of loan options that are, in most cases, better than home equity loans in the first place. The application processes for most of these loans aren’t too difficult, and none require you to put up your home as collateral. Before you pursue a home equity business loan, consider these options instead. Many are open to borrowers with less-than-perfect credit.
Equipment loans are a great option for small business owners who need to borrow cash in order to purchase the gear they need to run their company. These loans can be used for buying automobiles, kitchen appliances, software, medical machinery—basically, any kind of tools you need to keep your business going.
The best thing about equipment loans is that they don’t require additional collateral to secure. Similar to home equity loans, the equipment purchased through the loan serves as collateral itself: If you can’t make payments, the lender will take the equipment back. But in this case, you’ll only stand to lose your machinery if you can’t pay—rather than the roof over your head.
If you’re considering a home equity business loan to free up your company’s cash to make ad hoc purchases, think about getting a business line of credit instead. Both banks and alternative lenders offer business lines of credit, which function similarly to a credit card: You borrow money when you need it, and only pay interest on the money you’ve taken out as part of your loan.
But business lines of credit often have lower interest fees than business credit cards, and higher amounts you can borrow against, too.
You’ll usually end up paying less interest on a line of credit than you would on a home equity loan, chiefly because you don’t have to pay interest in the full amount of your loan—just what you actually use. That, and you won’t run the risk of losing your home if you can’t pay. (Starting to see a trend here?)
Many lenders offer business owners the opportunity to borrow money based on money they’re expecting due from customers’ unpaid invoices. This option, known as invoice financing, allows borrowers to receive up to 85% of the total value of their outstanding invoices while they wait for vendors to pay their bills. In exchange, borrowers will pay a small interest rate (usually 1 or 2% per week) until the invoices come in, as well as a flat processing fee of around 3% of the total sum of the loan.
This option is ideal for companies that need quick access to funds—if approved, you can access your invoice financing loan in as little as a day. You can also use these funds for whatever purposes you need, like payroll or inventory purchases. And, as you can guess by now, invoice finance lenders don’t require collateral aside from the invoice totals themselves.
Short-term loans aren’t always ideal, but they’re still safer than taking out a home equity business loan. These loans allow borrowers with less-than-exemplary credit access to quick cash, and online applications are pretty easy to complete. Plus, they don’t require borrowers to put down their homes as collateral—but they do come with steep repayment terms.
Most short-term loans require a rapid repayment, usually with daily or weekly repayment terms. They also come with much higher interest rates than other loan products, as the lender needs to make interest on their loan more quickly. They might not be ideal for borrowers, and short-term loans could affect your credit rating negatively if you don’t keep up with the repayments. But penalties are less severe than the forfeiture of your home.
Home equity business loans offer small business owners the opportunity to unlock the equity within their own homes, which otherwise sits dormant until the house is sold. But this equity comes at a price if your company goes under, is less successful than you expected, or if you simply can’t come up with your loan’s monthly payments.
As much as your home’s equity may feel like an untapped resource, you’ll have to consider if you realistically think your business can fulfill your obligations to your lender. If you can stomach the risk, you could take advantage of a great funding source. If you’re less confident, however, consider your alternatives—none of which pose the risk of losing your home for cash.
Brian O’Connor is a contributing writer for Fundera.
Brian writes about finance, business strategy, and digital marketing. He is the former director of digital strategy at Morgan Stanley, and has worked at Foreign Affairs magazine, Student Loan Hero, and as a partner of a small consulting firm, too. Combined, these experiences allow him to offer a unique perspective on the challenges small business owners face.