Table of Contents
When used properly, a home equity loan or home equity line of credit (HELOC) can provide homeowners with flexibility and financial resources to pay for various uses, ranging from home repairs and improvements to unexpected expenses, medical bills, college tuition, and more.
While these financing tools can give you much needed flexibility, the downside is that because they are essentially second mortgages, you must risk your house as collateral to secure the loan.
There are several instances of people using this leverage to finance the business of their dreams, and in many cases, if the business succeeds, the gamble is well worth the risk.
But it’s a big gamble, and you need to weigh this option carefully if you want to use home equity to start a business because the downside of business failure can also mean you could lose your home.
According to recent Bureau of Labor Statistics’ Business Employment Dynamics reports, about 20% of businesses with employees fail in their first year, rising to one-third failing in the second year and only about half making it five years in business.
The Differences Between a Home Equity Loan and a HELOC
Home equity loans and HELOCs sound like they should be the same, and they are in one major respect — they’re a second mortgage on your home that you’ll have to repay. But they have many differences.
A home equity loan has a fixed rate, loan amount, and repayment schedule. It’s a one-time lump sum loan repaid monthly, like a regular mortgage.
However, a home equity loan has higher payments than a HELOC because you’re repaying both principal and interest monthly.
A HELOC works like a credit card. It has a variable interest rate, and you can use the equity, when needed, up to a predetermined amount.
You can borrow against a HELOC for a certain period, usually five to 10 years, and you’re only charged interest when you withdraw funds. You also only pay interest during this draw period, so the monthly payments are lower while you’re not repaying the principal.
After the draw period, it converts to a fixed-rate loan for principal repayment. You can no longer withdraw funds during this time and must pay off the entire HELOC balance.
The interest rate will vary with a HELOC, so your costs will go up or down as dictated by market conditions unless you convert the HELOC to a fixed-rate loan at some point.
Can You Deduct Home Equity Financing if You Use It as a Business Loan?
In some cases, the answer may be yes. Before the passage of the Tax Cuts and Jobs Act of 2017, you could take out a home equity loan, use it for any purpose, and deduct the annual interest you paid on your tax return.
That changed for filers who took out home equity loans after December 15, 2017.
The most significant change in the law is that loan money must now be used to “buy, build or substantially improve” the home used to secure the loan. The law eliminated deductions if a loan was used for other purposes, such as to pay off a large debt, cover emergency expenses, or any other use of funds not directly related to improving your home.
So, if you use a home equity loan to build out a home office, you may be able to deduct interest, saving you thousands of dollars over the life of the loan. However, there are limits to how much you can claim, and you’ll need to itemize your deductions to document the use of the loan proceeds.
Your best bet is to consult with your tax pro to see if this is an option for your circumstances.
» MORE: See today’s refinance rates
Using Home Equity Financing vs. Taking Out a Business Loan
The obvious downside of using your home as collateral when you finance a business using a home equity loan is that you risk losing your home if your business fails and you can’t make your loan payments.
However, securing home equity financing may be easier, especially if you run into problems securing a small business loan or don’t qualify for whatever reason. Home equity interest rates are lower than business loans because the mortgage lender isn’t taking on the risk of your business.
Traditional small business loans can require a lot of paperwork. A bank may require a projection of income and finance for the business, personal financial statements, business lease, business plan, and three years of tax returns, among other things.
The smaller your business, the less likely you are to get a bank loan, and depending on your source, the cost to borrow money could be much higher. The interest rate on a small business bank loan may run as high as 11% or more, and Small Business Administration loans can run 15% APR or higher.
Business lines of credit aren’t cheap either, with rates starting at 10% or more.
Another thing to consider is that business loan fees are usually unavoidable and make borrowing more expensive. Small-business lenders charge upfront fees depending on factors like the size of your loan, the repayment term length, credit score, and the type of business loan.
More Flexibility with Home Equity Financing
Money from a home equity loan or line of credit can be used any way you wish, while business loans are often restricted in their use.
The interest on a home equity loan or HELOC may be tax deductible, as noted above, and you don’t have to pay it down to zero every year, as most business lines of credit require.
Home equity loans are also more flexible because they can be financed over 15 years. That gives you added flexibility if your business income varies or you have other debt obligations that could impact your personal finances from time to time.
While your monthly payments may be lower, when you extend payments out for several years using home equity financing, you’ll pay more interest in the long run. If you choose a business loan with a shorter repayment period, you will pay significantly less interest over the life of the loan.
But that flexibility with home equity borrowing comes at a cost. When pledging your home as collateral, the debt generally can’t be discharged in bankruptcy if the business fails.
For this reason, if you use home equity to finance your business, do everything you can to ensure the business is profitable as quickly as possible. That way, you can put yourself in a position to refinance or pay off the debt as soon as possible to mitigate the risks to you personally.