Betting the ranch on a dream:
Using home equity to fund a business
By Jennie L. Phipps • Bankrate.com

When Meg Reimer set about turning her beaded jewelry hobby into a business, the only money she had to buy beads and packaging was tied up in her house. So she, like many other entrepreneurs with an idea and no cash, started her business with a home equity loan.

Reimer was offered a teaser rate of 6 percent for the first six months. That deal was perfect for Reimer, who hoped that by the time the rate rose to prime plus 2 points, she'd have sold most of her creations and be in a position to pay the entire $20,000 back.

As things turned out, business wasn't as brisk as Reimer had expected and she ended her first selling season still owing $10,000. And she eventually borrowed more against the home equity credit line to add to her inventory.

Words to the wise
Financial experts are unanimous in their warnings to people such as Reimer. As Jeff Simmons, a partner with the accounting firm of Raphael and Raphael LLP in Boston, says: "The reason that you went into this business is to support the family. You don't want it to backfire and have it cost you your home."

That said, putting your largest asset up as collateral can be the most cost-effective way for someone without a banking relationship or any established business to get enough cash to get going. It's not ideal financing, but it's often better than credit card debt or a signature loan because the rate is lower and the deal is more flexible.

If you're married and the property is jointly owned, you'll need your spouse's signature. But lenders often will require joint personal guarantees on commercial loans as well when a business is young and has no track record. So don't feel this is an unusual risk.

A few options
There are two kinds of home equity loans: closed-end loans and lines of credit. A closed-end loan is what most people think of when they hear the phrase "second mortgage." The rates can be very competitive, the repayment term can be up to 25 years and closing costs are usually low, with closing available quickly.

A line of credit is much more flexible. It allows the borrower to draw money from time to time up to a specified limit. Payments are made on a schedule based on the outstanding balance, not on the maximum credit line, and you can take up to six years to pay it off. If the borrower doesn't use any of the money for a time, nothing is owed. The rate is usually lower than a home equity loan. For the current rates on both home equity loans and lines of credit, nationally and locally, see the see the Bankrate.com loan rate search engine.

A third possibility is a cash-out refinancing. While not defined as a home equity loan, it accomplishes the same thing -- it puts the equity in your house to work. The rate on these loans is often lower than a home equity loan, but closing costs of 3 percent or even more will probably apply. This kind of loan also takes longer to process. Six weeks is not uncommon.

Which is the best for someone contemplating this kind of small business financing? Dean Caso, president of Homevest Mortgage Corp. in Newton, Mass., recommends refinancing because of the low rate and the up-to-30-year repayment time. While this can be expensive financing, it doesn't have to be as long as there is no prepayment penalty and you repay aggressively.

Here's how a cash-out refinancing might work. Let's say you own a house that is now worth $250,000 and you owe $100,000 on the property. Homevest Mortgage is typical in being willing to let you borrow up to 90 percent of your equity, which in this case means that you can get a new 30-year mortgage for $225,000. After you pay off the old mortgage, that gives you $125,000 to do with as you please, including invest in a business.

Staying on the day job
It is easiest and cheapest to get a home equity loan or to refinance your home when you're getting a steady paycheck working for somebody else. So if you're contemplating starting a new business, but still on the job, do your refinancing first. Caso says telling your mortgage banker that you're going to use the money for your small business (as opposed to a vacation or home remodeling) may not be a good idea, because the banker may feel obligated to send you to the commercial side of his business. Caso recommends a "no-ask, no-tell policy."

On the other hand, if the banker does ask and you lie, you're committing fraud -- never a good idea. Moral issues aside, lenders usually forbid you in your loan documents from misrepresenting yourself. The penalty is that the loan is yanked and must be repaid immediately.

If you have already left your regular job, persuading someone to give you a home equity loan or refinance your house can be more difficult. If you have a good credit history, you may qualify for a "no-ratio" or a "no-doc" loan.

A "no-ratio" loan requires that you have two years' worth of work or self-employment history. For an extra half point of interest over the going rate, the mortgage company will ignore its usual guidelines, which says you can't owe more than 38 percent of your net income to your creditors on a first loan and up to 50 percent on a second.

A "no-doc" loan is particularly good for self-employed people who have a hard time proving their income. For an extra 2 percentage points over the going rate, the mortgage company won't ask for any income documentation and take your word for your ability to pay them back. You may have to search for this kind of loan, but they're out there.

Tax consequences
From a tax point of view, home equity loans are fully allowable as a business expense. The fact that they also can be taken as a personal deduction is immaterial, unless your business is incorporated as an "S" corporation.

Jeff Simmons, a partner with the accounting firm of Raphael and Raphael LLP in Boston, says you should not tell the bank you want to borrow money for your company, and offer as security a second mortgage on the house. If you do it that way and the bank lends the money to the corporation, you may not be able to write off the amount of the loan should you lose it.

Tax laws offer a formula for figuring out how much money you can deduct as a loss. To determine that amount, add all the money you contribute to the corporation plus all the profits the corporation has made. Then subtract any losses the corporation suffers and any money you take out of the corporation in profits or salary. Let's say you put in $5,000 of your own money and the corporation borrowed $25,000 from the bank with your house as collateral. In the first year you lose $10,000. With this kind of setup, you could only deduct $5,000, according to IRS regulations.

To get around this, personally borrow $25,000 as a home equity loan and lend that money to the corporation. Then, according to IRS rules, the corporation can deduct the entire $10,000 in losses if you have that much bad luck. The rules don't apply to sole proprietors.

As Simmons says, "The law is irrational, but unless you follow the rules, it can cost you a lot of money."

Jennie L. Phipps is a contributing editor based in Michigan

-- Updated: Sept. 10, 2001