Though many business owners at some point tap into home equity as a financing source, you need to determine whether this strategy is right for you. The two primary kinds of home equity debt are: The home equity loan which is a one-time lump sum that is paid off over a particular amount of time with a fixed rate and number of payments and the home equity line of credit which works more like a credit card because it has a revolving balance. Interest is due on the outstanding balance and that rate may vary over time.
As long as your home has appreciated in value, there will be a bank or mortgage broker who wants to loan you money in the form of either a home equity loan or line of credit right up to your credit limit. It's in their best interest because they make more money that way. Yet just because you qualify for a home equity line doesn't mean you need to use it, particularly as a bank for investment purposes.
Quite a few things need to go your way for you to use your home equity line effectively. While home equity loan interest rates may cost you less than borrowing from other sources, such as a bank or even from a brokerage account, you still need to be very careful and perform your due diligence.
To borrow home equity effectively, you need stable interest rates and rising home values. In other words, this strategy works best during a strong economy. It's up to you and/or your team of advisors to determine the pulse of the local and national economy
The Line of Credit
A home equity line of credit is different in that the borrower takes cash from it as needed. The time in which one is able to withdraw money (also called a draw period) usually lasts 10 years. The borrower does not need to pay anything back on a home equity line of credit unless he or she takes money from it. Any money taken from the line of credit must be repaid in its entirety, along with any interest, by the end of the draw period. Interest on this type of loan is variable.
If you overestimate the profits of your new business — and many, if not most, new small business operators do, you will need to dip further into your credit line. You do not want to put your home at risk in order to make a living.
If your home equity line of credit carries an adjustable interest rate, your rate may increase considerably. Consider that the money you borrowed would cost much more, thus cutting into any gains you would have made. Interest rates are at an all-time low; however, it is best to be cautious.
What do you need to know? Funding a small business using a home equity loan is inherently risky. Since you are using your loan or line of credit to fund a business as opposed to renovating a property, you might not be able to deduct the interest on your tax return; therefore, you may be stuck paying tax on capital gains. Also, if you have a financial or medical emergency, and the equity in your house is tied up in your business, you will end up in trouble if you have no other liquid asset to draw upon. However, once you have carefully considered both the risks and the opportunities, and have decided to move ahead, there are things that you can do to lower your exposure.
How to Lower Your Interest Rate
First, make sure that all your other debts are paid before applying for a home equity loan or line of credit. This includes credit card debt, student loans, and any other outstanding loans. Paying off all outstanding loans will raise your credit score and increase your chances of getting a lower interest rate.
Borrow Less to Keep Interest Payments Down
Borrow only what you need, even though lenders will allow you to borrow up to 80% of the current worth of your home. You may be tempted to ask for more, but you do not want to be paying interest on a larger amount on a home equity loan; likewise, you do not want to be tempted to dip into a bigger till with a line of credit.
Shop Around for Best Rates
Next, shop around. There are several home equity loans and lines of credit available today. Since you are making a long-term decision that carries some risk, you really want to be sure you are making the correct choice.
Consider staying at your day job until you get your loan. A guaranteed paycheck increases your chance of getting your loan. Finally, remember that borrowing from the equity in your home entails risks, so be sure you perform your due diligence in order to make the correct decision for you and your family.
In summary, here are the things you should discuss with a trusted financial advisor before tapping into your home equity:
* Will your investment deliver a greater after-tax return than you'll be paying for the loan?
* Does your home equity loan or line carry an adjustable rate? If so, a jump in interest rates may make what you owe even more costly and further offset any gains you make in your investment. If rates fall, it's good news, but given current conditions, it makes sense to be cautious.
* How much is property appreciating each year in your neighborhood on average? Is it enough to further offset the cost of your investment? Keep in mind that no one is predicting the type of double-digit property appreciation we saw before 2004.
* How will this loan work for you from a tax perspective? Keep in mind that interest on home equity loans is generally not tax-deductible if you aren't using the debt to buy or renovate a property.
* What if you need your home equity borrowing power later for an emergency--the real reason most of us should open a home equity line and then avoid using it? Could you handle that emergency if your borrowing was strained to the maximum?
* How liquid is this investment? If you had a sudden major expense, could you turn it into cash without major hardship?
* How much other debt do you have? Do you have significant balances on creditcards or auto debt? That may raise the rate you pay on your loan - another potential cut in your investment profit potential.
* From a cash flow perspective, will you be able to service the debt--make the loan payments--assuming your investment using the home-equity funds doesn't work out?
* Home equity is a good option for many important financial goals, but you have to balance risk against potential reward. In many cases, it's good to hold home equity in reserve for a real rainy day.