Betting the ranch on a dream:
Using home equity to fund a business
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.
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.
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
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.
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
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.
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