Can you use a home equity loan for business?

If you want to start a business but can't fund it yourself, there are numerous financing options you can consider. As a budding entrepreneur, you can ask your family members to invest in your ideas, apply for business loans, pitch venture capital firms, use personal loans, and more.

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If you’re a homeowner, you can also use a home equity loan to fund your business. The benefit of a home equity loan for business is you can use the funds for various purposes, including start-up capital. If you want to learn more about using a home equity loan to start a business, here’s how it works.

Can I use a home equity loan to start a business? 

Yes, you can use a home equity loan to start a business or to grow an already existing business. However, getting a home equity loan has advantages and disadvantages that are worth consideration before using one to fund your business venture.

How does a home equity loan work? 

First and foremost, a home equity loan is a loan that uses your home as collateral. Typically, lenders allow you to borrow 80% to 85% of your home’s equity. Then, you make equal monthly payments for a set term.

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Lenders will likely require you to have a certain amount of equity in your home, a specific credit score range, and a debt-to-income ratio under a certain percentage to qualify for a home equity loan. 

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The downside to a home equity loan is that if you cannot repay it, it’s possible your lender could foreclose on your home, a risk you should carefully consider.

Advantages of using a home equity loan for business

There are numerous advantages to using a home equity loan for your business financing.

Flexibility

When you get a home equity loan, there are no stringent rules or requirements regarding how you allocate the funds you receive. You can use the money for a variety of start-up costs, whether it’s to purchase inventory, pay rent, or make payroll.

Interest rates

The interest rate on a home equity loan tends to be lower than other financing methods. For example, home equity loans typically have lower interest rates than personal loans and credit cards.

Speed

Typically, it only takes a few weeks to receive funds from your home equity loan, depending on the lender. If getting access to funds quickly is your priority, ask potential lenders how long funding usually takes before selecting one. A 30-day closing is common in the industry.

Disadvantages of using a home equity loan for business

Of course, there are also some disadvantages to consider before using a home equity loan for your business financing.

Risk of default

The biggest disadvantage and the most crucial one to be aware of is you could lose your home if you don’t make your payments. Your home is the collateral for your home equity loan - or any equity financing product. As such, assess your risk tolerance before funding your business with a home equity loan and make sure you understand the loan requirements. 

Limited funding

You can only get a home equity loan for up to 80% of your available home equity. So, your loan amount is limited based on how much your home is worth and the equity you currently have in it. This might not work for businesses in need of large funding amounts.

Repayment regardless of outcome

Like any other loan, you are responsible for repaying your home equity loan. Even if you don’t create a profitable business and have to close it, you are still on the hook for monthly loan payments during your repayment period.

Income requirements

Most lenders will ask to see W2s to verify your income. Home equity loans for self-employed borrowers or entrepreneurs can be challenging to obtain, but not impossible.

Won’t build business credit

When you apply for a home equity loan, you apply using your personal credit so it does not build your business credit. In order to build your business credit, you would need to open a business bank account and establish credit with vendors who report to business credit bureaus.

Applying for a home equity loan

If you're interested in applying for a home equity loan, there are a couple of steps to take.

Gather necessary documents

To apply for a loan, your lender will likely need documents like tax forms, proof of income, mortgage documents, your latest bank statements, and more. The documents required will vary by lender.

Select a lender

Do your research when it comes to selecting a lender. Getting quotes from three to five different lenders is important to find the best rate and terms. Pay attention to lender fees and not just interest rates when deciding which lender is best for you. 

Be mindful of red flags

As you are researching lenders, be mindful of red flags. Write down the lenders you are considering, and speak with each one. If they give you an offer, ask for the terms in writing. If you have questions about the terms of the offer, ask questions.

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Be wary of lenders who overpromise, ask you to borrow more than you need, or, in general, engage in practices that make you uncomfortable. If a lender won’t put their terms in writing or promises something outside of the listed terms, be wary. 

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Only work with a lender who makes you feel comfortable, who respects your budget, and who answers your questions clearly. 

Alternatives to a home equity loan for business

If you decide not to take out a home equity loan to fund your business, several other funding options exist.

HELOC

A home equity line of credit (HELOC) is another popular option for homeowners looking to leverage their equity. It operates like any line of credit where you can use what you need up to a certain limit and repay what you used. Unlike a home equity loan, HELOCs can have variable interest rates.

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To qualify for a HELOC, you'll need 15% to 20% equity, a credit score above 680, and sufficient income.

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When it may be a good idea: A HELOC makes sense if you expect ongoing costs and want a flexible form of financing.

Home equity investment (HEI)

A home equity investment is another financing tool that allows you to leverage your equity. You can get a lump sum payout in exchange for a percentage of your home's future appreciation.

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There are no monthly payments over the 30-year term. Instead, you repay the investment with a balloon payment when you sell the home or refinance. You can buy back the equity anytime during the term, penalty-free.

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HEIs have no income requirements; you just need a credit score above 500, sufficient equity, and a home or investment property in an eligible area.

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When it may be a good idea: HEIs make sense for those who don't want to constrict their monthly cash flow or who are low-credit/low-income borrowers.

Small business line of credit

If using your home as collateral feels too risky, a business line of credit is worth exploring. Similar to what a credit card offers, you can borrow funds as needed and only pay interest on the funds you use. However, business lines of credit have lower interest rates than credit cards. This makes it ideal for managing cash flow, covering unexpected expenses, or taking advantage of short-term opportunities.

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Lenders typically require a solid credit score, often 600 to 680 or higher, and a history of profitable business operations to qualify for a small business line of credit. Additionally, you'll need to provide financial documentation to demonstrate your business's ability to repay the borrowed funds.

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When it may be a good idea: You want to cover ongoing expenses without using your home as collateral.

Small business credit card 

A small business credit card works similarly to a personal credit card. If approved, you can use your credit card for business expenses up to your limit.

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Like other credit cards, business cards typically have a high interest rate. Credit cards are convenient for everyday business expenses, but they might not be the best financial option if you can’t pay them in full every month.

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When it may be a good idea: You have small expenses to cover and can pay off the card in full to avoid high-interest payments.

Personal loan

Personal loans are unsecured financing options that don't require any collateral. Instead, approval is based on your creditworthiness as a borrower. Although you can find loans for bad credit, they generally have much higher rates.

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When it may be a good idea: Although personal loans are not a great long-term solution, they can help a business owner in a bind.

Cash-out refinance

A cash out refinance is when you get an entirely new mortgage and in the process, withdraw your equity in cash. This timeline for this product takes longer than getting a business line of credit or a small business credit card. It involves getting a home appraisal, paying closing costs, and securing a new mortgage loan, typically for larger than the mortgage you have.  

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When it may be a good idea: When mortgage rates are low, refinancing can you give you cash and help streamline the loan repayment process.

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Final thoughts

There are many ways to fund your small business, and getting a home equity loan is one. It’s important for entrepreneurs to be aware of the pros and cons of this financial product before applying for a home equity loan.

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However, if you understand the risks and want a straightforward funding option, a home equity loan can be a useful tool to help you start your business.