It can be tricky for new startups and small businesses to raise capital that they need to grow or[1] start their business. One option available to small business owners is collateralized loans, that has the borrower’s personal residence as collateral. This could be in the form of a mortgage refinance, a home equity line of credit (HELOC), or a home equity loan as a second mortgage.
A collateralized loan is easier to be approved for compared to regular small business loans. You might not need to provide your cash flow projections or present your business plan when applying, and being a secured loan allows you to get a lower interest rate. However, using your home as collateral for a loan can expose you to additional risk. If your small business fails and you’re unable to keep up with your payments, you might lose your home.
How do small business owners get financing?
In 2011, Innovation, Science and Economic Development Canada (formerly Industry Canada) found that 79.5% of Canadian small and medium-sized enterprises used the owner’s personal savings as startup capital, while 54% used the owner’s personal savings for day-to-day operations. 39.7% of small and medium-sized business owners have also used their personal assets as collateral for financing.
While most small businesses use business assets as collateral, such as their equipment, property, inventory, or accounts receivable, the use of the owner’s personal assets as collateral is becoming increasingly attractive. This is particularly true when looking at Canada’s housing market, with the prices of homes rising significantly in the past year. As the value of homes increases, the value of your collateral also increases. This allows small business owners access to a larger collateralized loan.
Types of collateralized loans
Home equity line of credit (HELOC)
With home values skyrocketing across the country, many homeowners now find themselves with a large amount of equity sitting in their homes. Home equity is the difference between the value of the home and the mortgage and other debt on the home. A home equity line of credit puts your home equity to work, and lets homeowners unlock their equity without having to sell their home.
A home equity line of credit works just like a credit card, but it’s secured against the value of your home. This makes a HELOC a great way to supplement your cash reserves or to fund day-to-day operations of your business. You will only need to pay interest for the amount that you actually use, and you can freely borrow and repay into your line of credit at any time.
A HELOC is easy to be approved for when compared to an unsecured loan, and HELOC rates are also quite low. The flexibility of a HELOC also allows it to be used for both day-to-day expenses and working capital, but can also be used for capital expenditures if your credit limit allows for it. A downside of HELOCs is that they have variable interest rates, which means that there is some level of uncertainty in the cash flow of your repayments if interest rates increase.
Home equity loan
A home equity loan as a second mortgage is similar to a HELOC, but the main difference is that it is a one-time lump-sum loan with a fixed interest rate. This makes it great for large capital purchases as you’ll be able to lock-in an interest rate.
Since a home equity loan is a personal loan, it will be separate from the business. You won’t have to worry about not qualifying for a home equity loan based on the strength of your business, but you’ll still need to have sufficient home equity in order to qualify.
Mortgage Refinance
With a mortgage refinance, you can increase the amount of your mortgage to borrow the difference in cash. This cash can be used for your business expenses, to pay down business debt, and to invest in your company. Refinancing your mortgage unlocks equity in your home just like a home equity loan or HELOC, but it will be on your primary mortgage. This means that you’ll be able to borrow a large lump-sum amount at a low interest rate, most often lower than HELOC rates and home equity loan rates.
Is using my home as collateral right for me?
HELOCs, mortgage refinancing, and home equity loans are easier to qualify for, they can offer lower interest rates, and they can be more flexible compared to business loans. You can use the money borrowed from these loans for anything, not just for your business too. In comparison, business loans may have conditions on what you can spend it on or use it for.
However, putting your home up for collateral can be risky. If your business fails, you will be at risk of not just losing your business, but losing your home as well. Business loans will look at your company’s history of revenue to see if you’ll be able to afford a loan. The strict lending guidelines for business loans help ensure that business owners can afford their loan. Using your personal home to get a HELOC allows you to bypass this check, but it also means that you might be overleveraging yourself.
Your home can also only be put up for so much. Larger businesses might require financing that requires a collateral where a personal home might not be enough.
Using your home equity to finance your business is more suitable for small businesses that don’t have a strong business credit score or haven’t been in business for several years. This is especially true for startups, where most startups rely on the owner’s personal savings and loans, as banks can be reluctant to lend to unproven businesses.
There are secured business equity loans in Canada, where your business assets are used as collateral, but this wouldn’t be an option for new businesses just starting out. Putting your home to work can let new business owners get access to financing that they otherwise wouldn’t qualify for.
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