The United States is home to many of the world’s most successful entrepreneurs, producing a steady stream of new businesses and entrepreneurs each month. According to the United States Census Bureau, for example, there are more than 420,000 applications for new business in April 2022 alone.
But as many entrepreneurs will tell you, the path to self-employment can be very challenging. One of the many challenges that new entrepreneurs face is how to raise money to finance their business. Traditional options include small business loans, personal savings or loans from friends and family. But as house prices have risen sharply in recent years, many entrepreneurs may be tempted to look at equity as a source of business finance.
- It is possible to use equity as a source of financing for a new business.
- This can be done through cash refinancing, equity loans or equity credit lines (HELOC).
- There are pros and cons to using equity for business purposes.
Using equity for business financing
The average house price in the United States rose by almost 80% between Q1 2012 and Q1 2022. Because equity is equal to the difference between the current market price of the home and its outstanding mortgage debt, many Americans have seen their equity increase with this increase in house prices. For homeowners in this advantageous position, there are several ways you can use your own capital as a source of money.
The easiest way to raise money from your own capital is, of course, by selling your home. If you adopt this approach, then your sales revenue will be approximately equal to your equity, minus all applicable taxes and closing costs. On the other hand, there are ways to extract money from your own capital while retaining ownership of your home. For example, you can undertake cash refinancing or acquire an equity loan or a domestic equity credit line (HELOC).
Refinancing with payment of money
As its name suggests, cash refinancing is a type of mortgage refinancing transaction in which you receive a lump sum in cash. It usually works by replacing your mortgage with a new mortgage at a time when your equity has increased since your first mortgage. Homeowners in this scenario can then pay off their original mortgage with the new mortgage by taking the difference.
To illustrate, consider a scenario in which you bought a home for $ 200,000 and secured a mortgage for 80% of the price of the home, or $ 160,000. A few years later, the home went up to $ 300,000. In this scenario, the bank can allow you to refinance using a new mortgage worth 80% of the current market price or $ 240,000. In this scenario, you will repay the previous mortgage and be left with $ 80,000 in cash. In practice, your actual cash flow would be less than that, as you will have to cover the closing costs. In addition, your income and creditworthiness will still have to meet the requirements for the new mortgage.
Housing loans and HELOC
If refinancing is not an available or attractive option for you, another approach would be to take out a traditional equity loan. Like cash refinancing, equity loans offer a lump sum cash and usually come with relatively cheap fixed interest rates and fixed depreciation schedules. They are provided by your home, so it is very important that you never miss any payments.
Another option would be to get a credit line for equity (HELOC). These loans work as revolving credit lines, allowing you to withdraw funds on a schedule of your choice, instead of receiving all proceeds from the loan at once. HELOC also allows you to pay only the interest on the loan, which allows you to minimize your monthly payments. While traditional home loans carry fixed interest rates, HELOC comes with variable interest rates, which means you are more exposed to interest rate risk. Although HELOC initially allowed a high level of flexibility, they automatically began to require scheduled principal payments after the end of an initial period – often set between five and ten years – known as the withdrawal period.
Advantages and disadvantages
As with most things in finance, each of these approaches has pros and cons. The main benefit of using equity to start a business is that it can be much more affordable while offering lower interest costs. Applying for a traditional small business loan can often be a challenging process, with many lenders reluctant to expand capital into an as yet unproven endeavor. A common saying among entrepreneurs is that “banks only want to sell you an umbrella when it’s not raining”. In other words, they are happy to give money to your business, but only when it is already successful and does not need funds.
Although relying on equity loans can help circumvent this problem, it is not without risks. After all, there is good reason why banks are reluctant to lend money to new businesses. As approximately 20% of start-ups fail in their first year and 65% fail in their first decade, there is no denying that there is a real credit risk. And because relying on equity means putting your own home at risk, entrepreneurs need to carefully consider whether this is a risk they are willing to take. To put it more clearly, using equity to start your business means that if your business fails, you could potentially lose your home.
Can you use equity as collateral?
Yes, you can use equity as collateral. When you take out an equity loan or HELOC, for example, your house is pledged as collateral for the loan. This means that if you fail to maintain your payments, the lender may foreclose on you and take ownership of your home.
Can I start a business without money or collateral?
Yes, it is possible to start a business without money or collateral, although of course whether this is possible or reasonable will depend on your specific tolerance for risk and circumstances. For example, an entrepreneur may start a business by selling equity to outside investors, receiving government subsidies, or relying on money from friends and family. Entrepreneurs with limited money will also often refrain from paying their salaries until their business becomes financially self-sufficient.
What type of equity loan allows you to get a lump sum?
Cash-on-refinancing or traditional equity loans both offer a lump sum at the time of the loan. HELOC can also be used in this way, as you can choose to withdraw the entire loan balance immediately. Keep in mind that, especially in the case of HELOC, this can put you at significant interest rate risk.
If, despite these risks, you think that using equity is still your best option, there are some additional steps that new entrepreneurs can take to help manage their risk. First, it is worth bearing in mind that – generally speaking – not all business ventures will be equally risky. By researching the industries and entrepreneurs in your area, you can determine that some types of business have a better chance of surviving than others. In addition, within a business, some uses of capital may be more risky than others. For example, inventories that are subject to the risk of reduction or deterioration may carry more risk than inventory that will retain its value indefinitely with limited risk of damage or depreciation.
Regardless of how you decide to finance your new business, conducting an in-depth inspection of your industry and competitors and creating a detailed budget that will allow you to plan and save your money is usually worth the time. Looking for the input of trusted advisors, such as experienced entrepreneurs in your area or a selected industry, can also help you maximize your chances of success.