Use Home Equity for Business Capital?

Question for Jim

What are your thoughts about borrowing against home equity to cover business needs? I’d like to expand my business and I’m considering if a home equity loan might be my best option. Thank you!

Here’s the good news! A home equity loan or home equity line of credit (HELOC) can be one of the easiest, and sometimes cheapest (via lowest interest), ways to get desired capital for your business expansion or startup. And that’s why it is often used by small business owners.

But that doesn’t make home equity financing a slam dunk for you. Simply having the ability to gain this type of financing does not make a business plan any likelier to succeed or establish the ability to repay it. And getting this type of financing can sometimes cause owners to miss or bypass caution signs that could have otherwise prevented them from starting or expanding into an unsuccessful business venture.

So, let’s cover a few situations where home equity debt might be considered, ranging from likely worst to best outcome possibilities.

Danger: Extreme Risk!

You’re likely heading for trouble if you take on home equity debt to fund your business if you have some or all of the following factors:

  • You are impulsive and have never done any planning like this 
  • You have poor credit management habits and don’t have or seek any help managing your business and personal finances
  • You have a business that experiences seasonal or cyclical drop-offs in activity and variable business revenues and profits
  • You have personal home equity you can borrow against, but lenders who are telling you they are not willing to lend to your business because they don’t think your plans can work

In these types of scenarios, home equity financing often results short-term gain in return for long-term pain. You may get the money you want to go ahead with your business idea or plans, only to find out you bypassed warning signals that were telling you not to take on the debt because you would struggle to manage it well and pay it back.

Note that these warnings relate to both your personal tendencies as well as to problems that can occur when matching the obligation of regular debts payments with business revenues and profits that vary by season or business cycle.

Maybe Yes, Maybe No

Home equity financing may or may not be the right call for you if you are facing some or all of these practices and characteristics:

  • you are careful in the way you manage your debt
  • you have an integrated personal and business budget something like this, and have set a plan to make sufficient business profit and cover debt payment installments
  • you are planning to start up or expand into a business that is unproven and dissimilar to other businesses, and no lenders are willing to lend to your business due to its high uncertainty of success

In cases like this, your ability to manage debt well leads to the “maybe yes” part of the answer to this question. And so, the key question becomes how likely your business plan is to succeed.

Banks manage lending risk for a living (not perfectly of course) and when they say “no” to lending to your business, you should consider whether their “no” is serving you as a free and helpful professional opinion to “be cautious and careful” or “don’t do it.”

Like most bank lenders, I favor investing as little capital as possible in unproven business models and plans at first… and prefer to start slow with unproven plans and attempt to prove in small scale that they can profitably succeed before investing (and borrowing) larger amounts of money right out of the gate.

If a dog’s gonna hunt, it usually does so as a pup! Apply that thinking to “maybe” situations like the one just described.

Sounds Like a Plan!

Though I typically favor matching business debt against business assets (vs. personal), home equity financing could be the right type of financing with this combination of factors:

  • Purchase opportunity is available where benefits (profits) far outstrip the costs of expected debt payments
  • You have spent multiple years working in the business for sale or in its industry, with successful experience in all aspects of its management
  • An established business with attractive assets, customers and a proven business model in a non-cyclical and non-seasonal industry available for sale:

o   Have an opportunity to make an immediate low-cost (or reasonable cost) purchase from owner you’ve worked under for multiple years

o   Have opportunity to make an immediate low-cost (or reasonable cost) purchase from successful retiring competitor in same industry,

o   Have opportunity to make low-cost asset purchase from distressed competitor with attractive assets, staff, and/or customer base

  • Selling owner is unwilling to offer owner-financing of purchase, and wants full payment immediately
  • Bank/credit union lenders are interested in lending your business money to proceed, but home equity financing interest would be less costly or under more favorable terms than borrowing through business
  • Very strong credit management history

The alignment of factors noted above is quite favorable. Business-specific or industry-specific management experience… proven and similar business/business model… non-variable business type… low or reasonable cost purchase opportunity… lender “buy in” that the opportunity is a good one… strong credit management practices.

In the select cases where these factors come into alignment, home equity financing can be a good choice and help you and your business advance to the next level of business development.

In most other cases, caution is advisable when considering home equity financing (or any financing) to make sure: (1) the business plan is very likely to succeed and pay for itself, (2) the business and you are both well-situated to manage the debt costs, and (3) it would not be better to borrow through the business backed by business assets vs. borrowing personally backed by personal assets.

Too Deep in Debt Already,

Looking for a way out?

First, know you’re not alone. Debt is easy to get into, but difficult to get out of. To help yourself with that battle, next time your business needs to start up or expand, first take the step of making sure you’ve got an investment-worthy business model. Often, a weak or flawed business model is at the heart of why debt can be so difficult to keep up with or escape.

So, to help you out of that trap, we offer this free business model test here. In completing this easy 5-minute exercise you may discover you’ve got a few “holes in your bucket.” But if you close them up, you may be pleasantly surprised at how quickly your leaky bucket begins to fill up… and then overflow!

And once you’ve gotten through that exercise, you can move on to making a specific plan to get out of the debt by using this helpful free tool.

Long live small business!
Long live small business owners!

Jim Smith, Founder, PERFORMIDABLE, LLC