Using Home Equity to Get a Business Loan Before you choose this risky method of financing, use this checklist to determine if it'll work.
By David Newton
Opinions expressed by Entrepreneur contributors are their own.
How do you figure out if it makes sense to take money fromone's personal residence to fund business activities? Let mesay first and foremost, funding any business activities is alwaysinherently risky, regardless of the source of the funding for theventure. Second, owning a home is a great American dream, so doinganything that puts that residence in jeopardy of foreclosure mustbe carefully considered. With those two things said, there is a wayto clearly understand how a loan funded through a personalresidence could provide capital for a business.
On the one hand, if your residence has around 20 percent equityand 80 percent loan outstanding on its value, then this strategyshould not be considered under any circumstances. First-time or newbuyers who have just put a 10 to 20 percent down payment (theirequity) on a home, and borrowed the balance, should not do any dealwhere a second lender comes in and writes a loan package to allowthe owners to cash out that 10 to 20 percent equity in exchange fora 100 percent refinance. That puts all your equity into yourbusiness with nothing left in your house. If you hit any difficulteconomic situation with the business and are behind or unable tomake your monthly mortgage, the second lender could very quicklyforeclose, and your equity and home are gone forever.
On the other hand, if you are a longer-time homeowner with morethan 50 percent of your home's value as equity (the loanoutstanding is less than half the market value of the house), thereis a way to figure out if borrowing from your home can work toprovide capital for your business. The best way to do this is withthis 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 combinedhere).
- Subtract the total debt from the appraised valuation; thedifference is your equity.
- Divide the equity figure by the appraised valuation; this isyour equity percentage. If this percentage is over 50 percent, thenthis could work for you.
- A lender will quote you a rate and monthly principal andinterest to borrow out equity. Some may want interest-onlypayments, so the loan balance outstanding does not get paid downover time.
- Determine what the funds will be used for in your business.Figure out what monthly revenues will be like after youborrow this money and put it into your business.
- Figure your gross profit margin on those monthly sales, andsubtract out your fixed monthly selling and general administrativecosts. You now have your targeted monthly operating income on apre-tax basis.
- Now plug in your minimum monthly payment to the lender who didyour home-equity funding deal. You'll make that monthly paymentfrom your pre-tax operating income in the business.
- Check with your tax advisor about how to best draw these fundseach month. Many suggest paying yourself just enough of a grosssalary or bonus so your take-home portion of this is equal to themonthly loan payment.
- Another way to make the payments is for you to make the loan tothe business, have the business repay you each month (no wages andpayroll taxes in this case), and then you use that receipt eachmonth from your business to pay your equity loan. In this case, theinterest charged your firm could be equal to the rate on your homeequity loan, and that interest paid could be tax-deductible to yourbusiness as well.
- If you can service the loan from your business operations, thiscan work for many months. As sales and your operating income grow,begin to make larger and larger payments to yourself each month toaccelerate 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 debtoutstanding and $120,000 in equity. Borrow $50,000 at 7 percentinterest only, so monthly payments are around $300 for $3,500 inannual interest due. The business will be able to show pre-taxprofits of around $5,000 per month and can easily cover the $300interest. Each month, the business pays the $300 in deductibleinterest and an additional $2,000 in principal reduction. At thispace, the entire loan could be paid back in about two years, thebusiness gets some much-needed capital, and the personal residenceregains 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 "verymanageable" level relative to the operating income of thebusiness. If the entrepreneur does not get overextended, then homeequity can be a good place to provide some capital for a growingbusiness.
David Newton is a professor of entrepreneurial finance andhead of the entrepreneurship program, which he founded in 1990, atWestmont College in Santa Barbara, California. The author of fourbooks on both entrepreneurship and finance investments, David wasformerly a contributing editor on growth capital for IndustryWeek Growing Companies magazine and has contributed to suchpublications as Entrepreneur, Your Money,Success, Red Herring, Business Week, Inc.and Solutions. He's also consulted to nearly 100emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are thoseof the author, not of Entrepreneur.com. All answers are intended tobe general in nature, without regard to specific geographical areasor circumstances, and should only be relied upon after consultingan appropriate expert, such as an attorney oraccountant.
