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Using a Home Equity Loan to Fund a Business

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While her children were growing up Mary often thought about starting a small business. Once her kids were in high school and more independent she decided to reach for her dream. After making a business plan she realized that she needed twenty thousand dollars to fund her business. Since she didn't have access to that kind of cash she decided to take the plunge and get a loan.

Her collateral was her home, which she had bought when the kids were small and had built up equity. According to her mortgage documents she had well over twenty thousand dollars available for a home equity loan. A visit to her local bank gave her the information she needed to make the right decision.

Second Mortgage or Home Equity Line of Credit?

Mary learned that many homeowners confuse the terms "home equity loan", "home equity line of credit" (HELOC), and "second mortgage". All three are loans that use her home as collateral, but there are some differences.

  • A home equity loan is any loan secured with the home as collateral. With this type of loan, a borrower receives a lump sum amount, and pays the loan back in monthly installments over a set period of time.
  • home equity line of credit (HELOC) is similar to a home equity loan, except that funds can be drawn over a period of time against a fixed credit limit. The borrower only uses what is needed, and only repays what was borrowed, and can continue to withdraw and repay money over an established period of time.
  • A second mortgage is simply a term to describe a loan that has the following two characteristics; it's secured by a home, and the mortgage is in the 2nd lien position (where the first mortgage is always in the 1st lien position). Therefore, both a home equity loan and home equity line of credit can accurately be called second mortgages. Most often, however, the term second mortgage is used to refer to a home equity loan.

A HELOC is like a credit card that Mary can access when she needs to. Like credit cards, interest is charged, and the credit limit is based on her credit rating. To determine the amount of her HELOC, Mary's lender examined the appraised value of her home and started their calculations at 75 percent of that value. They then subtracted the outstanding balance owed on the mortgage.

Mary had good credit, and her home was appraised at $300,000. Her lender determined the 75 percent base level of $225,000. Mary had paid off $75,000 of her original $250,000 mortgage, so her lender then deducted the remaining $175,000 from the base level of $225,000, which gave her a maximum of $50,000 available on a HELOC.

Mary and her lender agreed on a HELOC of $30,000. The draw period-the amount of time that she has to use the line of credit-was set at ten years. After the close of the draw period Mary has ten years to repay any outstanding balance. Her variable interest rate was tied to the prime rate. There was no loan fee.

A good deal? Only if Mary is serious about her business and makes a profit. What should she be concerned about?

  • The collateral for her business loan is her home. This is not without risk. If her business is successful, Mary will have no trouble paying off her home equity loan. But if her small business runs into trouble-as many do-Mary will have to find some other source of income to pay the balance on her HELOC.
  • The interest rate is variable. If it goes up, this could stress her business plan and force her to raise her profit targets.

The advantages to a HELOC? Mary can access the cash available to her only when she needs it. If business goes well then she'll need less loan money and will be able to repay it faster. Plus, with a HELOC she has access to cash anytime, just as if she had a credit card. Finally, as with any loan secured by a mortgage on your property, you often have the ability to deduct the mortgage interest on your income taxes.

Is a home equity line of credit the right choice for every small business owner? There are advantages and risks, and anyone considering a HELOC should consult a financial professional.