The Basics of Home Equity Financing
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What it is: In simplest terms, this is running up debt that uses your house as collateral.
Along with dipping into retirement savings, amassing credit card debt, and hitting up friends and families, home equity financing is one of the bootstrapping strategies that entrepreneurs turn to while starting up a business.
Related: Where to Get a Small Business Loan
How it works: Home equity financing often comes in two forms -- home equity loans and home equity lines of credit.
A home equity loan is a lump sum that is then paid back in installments. The terms of such a loan usually run five to 15 years versus the 30 years seen on a typical mortgage, according to Bankrate.com.
A home equity line of credit acts more like a credit card, with a limit on the total amount that can be taken out. The ability to take out more debt increases as principal is paid down.
No matter what form of home equity financing you choose, your credit history and income will matter, as will the present loan-to-value ratio on your home’s mortgage. This ratio is the amount of money still owed on the home divided by the home’s current appraised value. Note that this is not what the house was worth when you bought it, but rather what the appraiser hired by the bank says it is worth now.
Banks often like to keep the loan-to-value ratio below 80 percent.
Upside: It can be fast cash, which is often the best kind when trying to get a business going. Banks will also be eager to lend if the home’s value has been increasing.
Better yet, the home could end up helping you pay back the loan if its value continues to increase. Home equity financing, then, can be a smart form of debt in a stable, growing economy.
Downside: The U.S. economy has not been stable in recent years. A homeowner taking out home equity financing in 2006 and 2007 was in a difficult position when the housing bubble collapsed and the Great Recession set in.
Some people lost their homes. You could, too, if you aren’t careful, so think long and hard before tapping into home equity financing.
A safer option when interest rates are low is to refinance a mortgage, with the resulting lower monthly payments freeing up cash for operating the new business.