Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
How do you figure out if it makes sense to take money from one's personal residence to fund business activities? Let me say first and foremost, funding any business activities is always inherently risky, regardless of the source of the funding for the venture. Second, owning a home is a great American dream, so doing anything that puts that residence in jeopardy of foreclosure must be carefully considered. With those two things said, there is a way to clearly understand how a loan funded through a personal residence could provide capital for a business.
On the one hand, if your residence has around 20 percent equity and 80 percent loan outstanding on its value, then this strategy should not be considered under any circumstances. First-time or new buyers who have just put a 10 to 20 percent down payment (their equity) on a home, and borrowed the balance, should not do any deal where a second lender comes in and writes a loan package to allow the owners to cash out that 10 to 20 percent equity in exchange for a 100 percent refinance. That puts all your equity into your business with nothing left in your house. If you hit any difficult economic situation with the business and are behind or unable to make your monthly mortgage, the second lender could very quickly foreclose, and your equity and home are gone forever.
On the other hand, if you are a longer-time homeowner with more than 50 percent of your home's value as equity (the loan outstanding is less than half the market value of the house), there is a way to figure out if borrowing from your home can work to provide capital for your business. The best way to do this is with this checklist:
- Get a fair market appraisal on your house.
- Know the exact outstanding balance on all your mortgages (first, second, home equity line, other liens must all be combined here).
- Subtract the total debt from the appraised valuation; the difference is your equity.
- Divide the equity figure by the appraised valuation; this is your equity percentage. If this percentage is over 50 percent, then this could work for you.
- A lender will quote you a rate and monthly principal and interest to borrow out equity. Some may want interest-only payments, so the loan balance outstanding does not get paid down over time.
- Determine what the funds will be used for in your business. Figure out what monthly revenues will be like after you borrow this money and put it into your business.
- Figure your gross profit margin on those monthly sales, and subtract out your fixed monthly selling and general administrative costs. You now have your targeted monthly operating income on a pre-tax basis.
- Now plug in your minimum monthly payment to the lender who did your home-equity funding deal. You'll make that monthly payment from your pre-tax operating income in the business.
- Check with your tax advisor about how to best draw these funds each month. Many suggest paying yourself just enough of a gross salary or bonus so your take-home portion of this is equal to the monthly loan payment.
- Another way to make the payments is for you to make the loan to the business, have the business repay you each month (no wages and payroll taxes in this case), and then you use that receipt each month from your business to pay your equity loan. In this case, the interest charged your firm could be equal to the rate on your home equity loan, and that interest paid could be tax-deductible to your business as well.
- If you can service the loan from your business operations, this can work for many months. As sales and your operating income grow, begin to make larger and larger payments to yourself each month to accelerate the retirement of the principal.
The following example will shed some more light on this. Consider a home valued at $200,000 with $80,000 in total debt outstanding and $120,000 in equity. Borrow $50,000 at 7 percent interest only, so monthly payments are around $300 for $3,500 in annual interest due. The business will be able to show pre-tax profits of around $5,000 per month and can easily cover the $300 interest. Each month, the business pays the $300 in deductible interest and an additional $2,000 in principal reduction. At this pace, the entire loan could be paid back in about two years, the business gets some much-needed capital, and the personal residence regains the $50,000 in equity.
Certainly, all kinds of things could go wrong with such a deal. But the key is to keep the monthly debt service at a "very manageable" level relative to the operating income of the business. If the entrepreneur does not get overextended, then home equity can be a good place to provide some capital for a growing business.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.