Tips On Using A Home Equity Loan To Fund A Business
While her children were growing up Mary often thought about starting a small business
. Once her kids were in high school and more independent she decided to reach for her dream. After making a business plan she realized that she needed twenty thousand dollars to fund her business. Since she didnt have access to that kind of cash she decided to take the plunge and get a loan.Her collateral was her home, which she had bought when the kids were small and had built up equity. According to her mortgage documents she had well over twenty thousand dollars available for a home equity loan. A visit to her local bank gave her the information she needed to make the right decision.
Second Mortgage or Home Equity Line of Credit?
Mary learned that many homeowners confuse the terms "home equity loan", "home equity line of credit (HELOC)", and "second mortgage". All three are loans that use her home as collateral, but there are differences.
1. A home equity loan is any loan secured with the home as collateral. A home equity loan can be taken out on a home that is owned free and clear. The borrower receives a lump sum payout.
2. A home equity line of credit (HELOC) is the same as a home equity loan, except that funds can be drawn over a period of time against a fixed credit limit. The borrower only uses what is needed, and only repays what was borrowed, and can continue to withdraw and repay money over an established period of time.
3. A second mortgage is a specialized form of home equity loan that is taken out in addition to a first mortgage, usually at the same time that the first mortgage is established, and results in a lump-sum payment to the borrower. Second mortgages are usually 15- to 30-year loans with either a fixed or variable interest rate. Unlike mortgage refinancing, the second mortgage does not replace the first mortgage.
A HELOC is like a credit card that Mary can access when she needs to. Like credit cards, interest is charged, and the credit limit is based on her credit rating. To determine the amount of her HELOC, Marys lender examined the appraised value of her home and started their calculations at 75 percent of that value. They then subtracted the outstanding balance owed on the mortgage.
Mary had good credit, and her home was appraised at $300,000. Her lender determined the 75 percent base level of $225,000. Mary had paid off $75,000 of her original $250,000 mortgage, so her lender then deducted the remaining $175,000 from the base level of $225,000, which gave her a maximum of $50,000 available on a HELOC.
Mary and her lender agreed on a HELOC of $30,000. The draw periodthe amount of time that she has to use the line of creditwas set at ten years. After the close of the draw period Mary has ten years to repay any outstanding balance. Her variable interest rate was tied to the prime rate. There was no loan fee.
A good deal? Only if Mary is serious about her business and makes a profit. What should she be concerned about?
The collateral for her business loan is her home. This is not without risk. If her business is successful, Mary will have no trouble paying off her home equity loan. But if her small business runs into troubleas many doMary will have to find some other source of income to pay the balance on her HELOC.
The interest rate is variable. If it goes up, this could stress her business plan and force her to raise her profit targets.
The advantages to a HELOC? Mary can access the cash available to her only when she needs it. If business goes well then shell need less loan money and will be able to repay it faster. Plus, with a HELOC she has access to cash anytime, just as if she had a credit card.
Is a home equity line of credit the right choice for every small business owner? There are advantages and risks, and anyone considering a HELOC should consult a financial professional.
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