- 7 min read
- HELOCs can be good business loans for the right borrower.
- A home equity line of credit can be cheaper and easier to get than a traditional small business loan.
- However, business owners who borrow with a HELOC are putting their homes at risk.
Do you own a small business, or are you dreaming of launching one? This can be an exciting time, but also a costly one. That’s because business owners often need plenty of funds to get their enterprise rolling or sustain it. You could borrow funds from a loved one or take out a home equity loan or small business loan. But a better option may be applying for a home equity line of credit (HELOC).
A HELOC for business purposes could be just the financial lifeline you need to survive and thrive. Find out what’s involved, advantages and disadvantages, eligibility requirements, and alternatives to a HELOC for business.
How Does a HELOC Work?
According to the Consumer Financial Protection Bureau (CFPB), a home equity line of credit (HELOC) is a form of revolving credit for which your home serves as collateral. With a HELOC, you get approved for a particular amount of credit, which can be based on your home’s appraised value.
“A HELOC allows a homeowner to borrow against the equity they’ve built up into their home. It functions like a credit card where a borrower is given access to an amount of money up to a certain limit that they can borrow from as they need it,” explains Jacob Channel, senior economist for LendingTree.
The lender may determine your credit limit by setting a percentage of your home’s appraised value (for example, 75%) and subtracting the balance owed on your existing mortgage from that. Additionally, the lender will evaluate your means to repay the loan by closely examining your earnings, debts, financial obligations, and credit history.
You don’t begin making payments on a HELOC until after you start borrowing against your line of credit. A HELOC typically has a fixed “draw period,” such as 10 years, during which you can borrow money, per the CFPB. During your draw period, you are only required to make minimum payments on the interest you owe; however, you are permitted to pay off what you borrow in full.
After your draw period, you may be permitted to renew the line of credit. Once the draw period ends, you’ll likely be required to repay your balance due over a set period or in full, a time called the “repayment period,” which can last 10 to 20 years. If you make merely the minimum payment due each month, by the end of the term you will have to repay the remaining balance as a lump sum single payment, called a “balloon payment.”
Be aware that a HELOC’s interest rate isn’t fixed. Your rate is a preset variable rate based on current prime rates (plus a margin) that can rise or fall over time. The good news is that you only will pay interest on the cash you borrow.
Can a HELOC be Used for a Small Business?
Rest assured that funds from a HELOC are allowed to be used for a small business.
“The money gotten from a HELOC can be used for anything the borrower wants to use it for. It’s a popular choice for home improvement projects since that money will further boost the equity of the house in question. But it can also be spent on anything else,” notes Carter Seuthe, CEO of Credit Summit.
Channel agrees. “Fortunately, there aren’t very many restrictions and how you can use your HELOC, so long as your business expenses are legal,” he says.
Reasons to Consider a HELOC for Your Business
A HELOC can come in handy when you need extra money any time during the life cycle of your small business.
“HELOCs can provide you with a flexible source of financing. You can use the money for any purpose, and you only have to pay interest on the amount that you borrow,” Joshua Haley, founder of Moving Astute, says.
Most importantly, HELOCs usually charge lower interest rates than other forms of financing, including credit cards. This can save you money if you use a loan to finance business expenses.
“A HELOC can also be a good option if you need money for a one-time expense or if you want to consolidate multiple debts into one monthly payment,” adds Haley. “Some common uses for HELOCs include funding a business expansion, paying for inventory, or covering the cost of unexpected repairs.”
A HELOC is also a great option for a new small business to receive startup capital without seeking outside investors.
“It can provide a great windfall of cash to rent retail or office space, buy inputs or products, or start paying a labor force before your business has income,” adds Seuthe. “And since it’s a revolving line of credit, it can also function as a good emergency fund for your business or as a way to buy more products or services that take a while to pay off.”
Pros and cons of using a HELOC for a small business
The primary advantage of securing a HELOC for your small business is that you can potentially receive access to tens of thousands of dollars or more that you can use to pay for an array of business needs.
“Plus, you can get a lower interest rate than what you might find on other types of loans or financing, like a credit card or personal loan,” Channel continues.
Additionally, you can use HELOC funds to consolidate multiple debts into one simple monthly payment, which can be a wise strategy if those other debts charge higher interest rates than a HELOC would.
Furthermore, it may be easier to qualify for and secure a HELOC (if you own a home with sufficient equity accrued) than other financing options. However, the eligibility requirements are often stricter for small business owners than for personal borrowers, cautions Haley.
But the major drawback of pursuing a HELOC is that your home will be used as collateral. That means you could lose your primary residence if you cannot repay your borrowed funds according to the terms of the HELOC.
“You will eventually need to pay back what you borrow, and you may need to deal with a variable interest rate during your loan’s draw period,” adds Channel. “Even if your business fails, you will still owe what you borrowed on the HELOC.”
How to Qualify for a HELOC for Your Business
To be eligible for a HELOC, you’ll need sufficient equity built up in your home.
“Most HELOC lenders require you to have at least 20% equity. So if you own a home worth $200,000, you’ll need at least $40,000 in equity to qualify,” Haley says.
In addition, you need a good credit score to secure a HELOC. Most lenders seek a minimum credit score of 660, “although you may be able to qualify with a lower score if you have ample equity in your home,” notes Haley.
Be prepared to complete more paperwork and furnish financial documentation related to your business.
“The big issue for small business owners getting a HELOC is that it can be tough to prove your income when you are first launching your business,” Seuthe says.
Small business owners will probably go through the same process as anyone else when applying for and receiving a HELOC.
“But if you have a lot of other debts, or if your small business doesn’t produce a steady income, you may have a more difficult time getting approved than someone with a more stable income stream,” cautions Channel.
Is it a Good Idea to Use a HELOC for Your Business?
Applying for and using a HELOC to fund your small business can be a good idea if you are a well-qualified borrower applicant prepared to repay the funds on time and in full.
“But don’t do this without a safety net in place. You should probably either have a rock solid business plan where you can count on more income to repay the loan quickly or a partner to support you financially while you get things off the ground,” recommends Seuthe.
Remember that a HELOC comes with risks as well as rewards.
“If you are in a situation where your small business is losing a lot of money, and you are not sure how to keep it afloat, getting a new loan that you have to worry about repaying could just make your life more difficult,” says Channel.
Before pulling the trigger on a HELOC, take the time to shop lenders carefully and compare rates and terms from multiple lenders to get the best deal possible.
Alternatives to using a HELOC for your small business
Instead of a HELOC, you may want to consider other options:
- A small business loan provided by the U.S. Small Business Administration (SBA) or various lenders and banks
- An SBA limited grant, awarded to some small businesses that specialize in things like scientific research and development
- A home equity loan, which provides lump sum funds up front but which also uses your home as collateral
- A personal loan, which can be easy to qualify for but often charges higher interest rates.
Is it better to get a home equity loan than a HELOC for your small business?
The advantage of a HELOC is that you don’t begin making payments until after you begin borrowing against your line of credit. A HELOC usually has a fixed “draw period,” such as 10 years, during which you can borrow money and are only required to make minimum payments on the interest you owe. You can apply for a HELOC but never choose to use it unless necessary. In contrast, a home equity loan provides funds in full immediately upon closing, but you must start repaying the loan every month. A home equity loan typically charges a fixed interest rate, while a HELOC’s interest rate can vary. Both types of financing require using your home as collateral.
Can you lose your home if you cannot repay your HELOC?
Yes, your HELOC lender can foreclose on and take away your home if you cannot repay what you borrow on time and in full. You are required to use your home as collateral for a home equity line of credit.
Who’s a good small business owner candidate for a HELOC?
Any small business owner can be a worthy candidate for HELOC, provided they have sufficient equity accrued in their home (usually at least 20%) and the financial means to repay the funds borrowed in full and on time. The borrower must also own a home and have earned at least 20% equity in it.